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The program gets the incentives right.

As prescription-drug costs have risen steadily in recent years, politicians of both parties have made audacious claims that billions could be saved by imposing lower prices on drugmakers. Yet newly developed drugs are expensive because they are enormously valuable to patients relative to existing alternative treatments. Unless the patent system allows drugmakers to initially capture much of the value associated with these new therapies, multi-billion-dollar investments in research and development of new products will not be made. Price controls on patented drugs therefore come at the expense of future medical innovation, and politicians unwilling to make that trade are likely to be unable to greatly reduce drug prices.


As effective therapies can save thousands of dollars by keeping patients out of the hospital, reformers should instead focus on promoting new insurance arrangements to better protect enrollees from drug costs. Medicare Advantage is leading the way in this respect: shielding seniors from catastrophic costs, eliminating drug-benefit premiums, and reducing drug deductibles by an average of 67 percent relative to standalone Medicare drug plans. (By giving Medicare beneficiaries the option to receive health coverage from competing private insurers, MA allows seniors to receive more generous medical benefits by choosing more efficiently run plans.)

Drug prices are politically salient because they touch most seniors. Whereas only 15 percent of Medicare beneficiaries had inpatient hospitalizations in 2015, 91 percent used prescription drugs — with median drug spending of $902 per year. Americans therefore remain eager for politicians to generate major savings: A March 2018 poll found that 80 percent thought that prescription-drug costs are unreasonable, while 77 percent believed that President Trump and his administration were not doing enough to reduce them.


In 2016, when campaigning for election, Donald Trump repeatedly suggested that if the United States government were allowed to negotiate drug prices, it could save $300 billion per year. Senator Sanders made a similar claim, arguing that a transition to single-payer health care could reduce drug costs by $324 billion, even though total nationwide drug spending amounted to only $305 billion. On November 20, Senator Sanders and Representative Ro Khanna introduced legislation to cap drug prices in the United States at levels paid by other developed countries; they claimed this would reduce the median price of branded prescription drugs paid by Americans by 40 percent.

Once a drug has been developed, the cost of manufacturing it is normally trivial, so price controls could potentially yield enormous immediate savings windfalls to taxpayers, insurers, and patients. But doing so would wipe out future drug development. The average cost of developing a new drug, demonstrating its safety and efficacy, and bringing it to market has been estimated to be as high as $2.9 billion. Patents allow drug firms to recoup their investment by temporarily restricting competition.



But how much should we willing to pay for such drugs?

Nations differ in their willingness and ability to pay for improvements in health care. Affluent countries, which are willing to spend more to save lives by delivering a greater intensity of care in a hospital setting, will similarly be willing to pay more to access cutting-edge drugs. The share of health-care spending on prescription drugs is, if anything, relatively low in the United States (12.3 percent) by comparison with Canada (17.8 percent). Drug manufacturers know this, and will therefore develop new drugs on the expectation that that they will be able to cover a disproportionate share of development costs from wealthier nations. It therefore makes little sense to cap the rewards available for new drug development just because other countries have less ability to pay for it than Americans do.

If a branded drug merely replicates an existing generic drug, there is little reason to pay more. Drugs with the highest prices therefore tend to be those that offer unique advances on existing medical capacities. Although Gilead received much criticism for its pricing of Sovaldi, its $84,000 cure for Hepatitis C, this represents extraordinarily good value by comparison with the alternative $577,000 average cost of a liver transplant — a procedure that falls short of a cure and is prone to complications.


The prices of branded drugs are therefore most appropriately constrained by the ability of purchasers to switch to available substitutes at any given price. For this reason, prescription-drug plans often require that patients seeking the most expensive therapies try a cheaper alternative (“step therapy”) or receive approval (“prior authorization”) before purchase.


The Trump administration is therefore correct when it seeks to expand the capacity of Medicare Part D plans to employ these tools for prescription drugs, and for Medicare Advantage plans to do so for physician-administered drugs covered by Medicare Part B. But in both cases, the expected savings amount to a drop in the ocean: $0.14 billion out of $113.7 billion spent on Part D in 2020, and $0.14 billion out of $28 billion on Part B drugs. A further proposal to base payments for Part B drugs on average payments made abroad would likely excessively squeeze revenues, by coupling them to markets with a much lower willingness to pay for medical care — were it not for the likelihood that such metrics could be easy for drugmakers to manipulate with rebates, volume discounts, and other such shenanigans.

Overall, the proposed changes are likely to amount to little, and they fall far short of the claims made by Trump on the campaign trail and the likely expectations of voters.

Is there a better way? Yes, but rather than feeding the delusion that Americans can continue to enjoy pioneering drug development without paying for it, policymakers should instead focus on finding ways to better protect them from those costs.

Under Medicare Part B, beneficiaries must pay 20 percent coinsurance for physician-administered drugs — a potentially ruinous amount, given that 12 of 13 new cancer drugs approved in 2012 cost over $100,000. By contrast, Medicare Advantage plans are required to cap annual out-of-pocket costs for hospital and physician services at $6,700 — a comprehensive protection that many Medicare beneficiaries are unaware they lack if they fail to choose such a plan.

Medicare Advantage also provides better protection from Part D prescription-drug costs, which form the bulk of drug expenditures for Medicare beneficiaries. A patient can avoid a costly hospitalization by taking his drugs on the correct schedule, so MA plans have an incentive to cross-subsidize drug coverage to make sure patients aren’t skipping pills to save money. By contrast, in a “standalone” Part D plan that covers drugs and drugs alone, the insurer offering coverage doesn’t see the benefit of avoiding an expensive medical procedure.

As a result, whereas Medicare beneficiaries enrolled in standalone plans must pay premiums averaging $492 per year, the majority of Medicare Advantage enrollees receive Part D coverage at no additional cost. And even though access to prescription drugs is the same under both coverage options, by enrolling in Medicare Advantage, beneficiaries can reduce their annual deductibles from an average of $400 to $131.


Some organizations have criticized the Trump administration for doing too much to steer Medicare beneficiaries towards MA plans. If the administration really wants to help seniors cut their drug costs, it should do this even more.