In his budget deficit speech yesterday, Obama said, “We will cut spending on prescription drugs by using Medicare’s purchasing power to drive greater efficiency.” The accompanying White House fact sheet says, “The framework would limit excessive payments for prescription drugs by leveraging Medicare’s purchasing power – similar to what was called for by the bipartisan Fiscal Commission.”

But the bipartisan Fiscal Commission report says no such thing. About the Medicare drug benefit (Part D), it says only,

Drug companies are required to provide substantial rebates for prescription drugs purchased by Medicaid beneficiaries. We recommend extending these rebates to Medicaid beneficiaries who are also eligible for Medicare (individuals known as “dual eligibles”) and who receive prescription drug coverage through the Medicare Part D program.

That’s got nothing to do with leveraging Medicare’s purchasing power. Thus, if Obama’s statement about “purchasing power” of Medicare means anything for the Part D program, it’s something neither he nor the Fiscal Commission has specified yet. But what? My sample is small, but some have speculated he wants to make Medicare’s drug program more like the VA’s. If you know anything about the VA’s drug benefit, you’ll know that this would be a huge change for beneficiaries and drug manufacturers, and therefore politically unlikely. Yet, it is worth asking, what would happen if Medicare did buy drugs like the VA does?

Turns out, with colleagues Steve Pizer and Roger Feldman, I asked and answered that question in a paper titled “Should Medicare Adopt the Veterans Health Administration Formulary?” (funded by the Department of Veterans Affairs and the Robert Wood Johnson Foundation). It is soon to appear in the journal Health Economics. Journal editors have suggested I release a working paper version now (ungated) and discuss it in advance of publication on this blog. Below is a summary. The details and limitations are in the paper.

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Since January 2006 all Medicare beneficiaries have been eligible to obtain outpatient prescription drug coverage through private health plans. The Part D drug program made benefits available through HMOs and PPOs under the Medicare Advantage program (MA-PD plans). In addition, it includes new prescription drug plans (PDPs), which offer stand-alone drug coverage in multi-state regions.

In the paper, we compute the savings to the Medicare program and the loss of value (formally, consumer surplus) to beneficiaries due to tightening Part D formularies to the level found in the Veterans Health Administration (VA). (A formulary is a list of drugs covered by a health plan.) We measure formulary generosity as the percentage of the 200 most popular drugs covered. The VA’s national formulary covers 59% of the top 200 drugs while Medicare PDPs cover between 68% and 93% of those drugs, averaging about 85% covered. So, if Medicare plans looked more like the VA, a lot fewer drugs would be covered.

But, the tighter the formulary (the less drugs it covers) the more bargaining leverage a plan has with respect to drug manufacturers. Plans able to restrict drugs from their formularies have the clout to say “no” to high prices. This is one, but not the only, reason the VA can purchase drugs at prices 40% below those paid by Medicare Part D plans. If Medicare drug plans restricted their formularies to the level of generosity offered by the VA and obtained VA-like drug prices by doing so, we estimate that the program would save $510 per beneficiary per year or a total of $14 billion per year (2009 prices).

However, in tightening formularies, beneficiaries would lose low-cost access to many drugs. That loss of choice is worth something, and it can be monetized using econometric techniques. Doing so, we estimate the loss of choice to be valued at $405 per beneficiary per year. Because the savings ($510 per beneficiary) exceeds the loss of value to beneficiaries ($405), they could, in principle, be made whole with $105 left over (= $510 – $405). This could be done by lowering premiums, for example.

It’s worth asking, why are Part D formularies so generous? The reason is that a minimum of two drugs in each class must be included on formularies and six classes must include “all or substantially all” drugs on the market. Because of this, providing Medicare the authority to negotiate directly with manufacturers would not lead to price reductions on its own. To achieve savings, Medicare or its participating plans would also need the ability to exclude drugs from its formulary. This ability to tighten formularies would provide the leverage to bargain for lower prices.

Medicare’s inability to negotiate program-wide prices and tighten plan formularies is in stark contrast to the VA, which negotiates directly with drug manufacturers and is not bound by the same formulary rules as Part D plans. That’s why the VA has been able to implement a national formulary more restrictive than those of Medicare plans and obtains lower drug prices. If Medicare plans could implement VA-like formularies and obtain commensurately lower prices, our paper shows that enough could be saved to compensate beneficiaries for the loss of choice, with savings to spare.

To repeat, the key findings are:

The VA pays 40% less than Medicare plans for prescription drugs.

Medicare plans cover about 85% of the most popular 200 drugs on average (ranging from a low of 68% to a high of 93%).

The VA’s national formulary includes 59% of the most popular 200 drugs.

If Medicare obtained the same drug prices as the VA, it would save $510 per beneficiary per year or a total of $14 billion per year (2009 prices).

If Medicare plans tightened formularies to the level of generosity available from the VA (59% of top 200 drugs covered), beneficiaries would lose $405 of value per year associated with the loss of choice of drugs. (The right way to interpret this is that the average beneficiary would be precisely indifferent between the loss of drug choice and $405 dollars in cash.)

Because the savings ($510 per beneficiary) exceeds the loss of value to beneficiaries ($405), they could, in principle, be made whole with $105 left over (= $510 – $405).

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