Fixing Drug Pricing Means Paying For “Value”

The following is a guest post by Yevgeniy Feyman, a senior research assistant in the department of health policy and management at the Harvard T.H. Chan School of Public Health. His research focuses on a range of topics including hospital quality and Medicare Advantage. Previously, he was deputy director of health policy at the Manhattan Institute for Policy Research.

The way we pay for prescription drugs is more complex than the way we pay for anything else in the health system. And at some level, that makes sense.

When we pay for innovative medications (those with patents or FDA-granted market exclusivity), we’re not paying just for the pill – we’re paying a high price to incentivize the 10 years of clinical research needed to get that drug through the FDA approval process, and all the failures along the way. This high price is often negotiated down by various middlemen, but it nevertheless remains a “monopoly price.” Patents, along with FDA-granted market exclusivity, preclude competitors from marketing the same drug under the same or different name for a period of time.

And unlike other OECD countries, the U.S. doesn’t have any national, price controls, profit controls, or other active or passive forms of across-the-board price regulation. This makes the American drug market unique, both in its strengths and weaknesses. Drug pricing reform should ideally protect those strengths while minimizing the weaknesses. But before jumping into what those weaknesses look like (and how we might think about fixing them), it’s worth recapping how we pay for drugs.

What we pay depends on who’s paying

This is basically true across the health care system, and is equally true in pharmaceuticals. The widely or publicly disclosed price of a drug is never really the price. There is a sticker price –  an “average wholesale price” (AWP) of a drug. (This is often used interchangeably with a related price called the “wholesale average cost,” or WAC, which is what manufacturers typically charge wholesalers.) This is the price that makes news headlines and generates all sorts of furor among activists, but mostly no one pays this price.

In the private sector, insurers typically contract with pharmacy benefit managers (PBMs) to negotiate down this price. The uninsured may be left paying the full price, or may receive financial assistance directly from the company or other organizations.

Things are much more complicated when considering the numerous public sector programs that purchase drugs. The nation’s Medicaid programs receive mandatory rebates tied to the best price that drug makers offer private sector payers. The Veterans Administration (VA) maintains its own separate formulary for covered drugs and negotiates its own prices (about 40 percent less than Medicare pays). Medicare Part B (which pays for outpatient drugs) reimburses based on average sales price plus six percent. (CMS is has proposed experimenting with changes to this approach, with an average sales price plus 2.5% reimbursement, topped off with a flat-fee). Retail prescription drugs under Medicare Part D are paid for based on prices and formularies negotiated by private insurers and PBMs. The 340b program requires drug manufacturers to provide significant discounts for outpatient drugs to certain providers (typically hospitals), and makes up close to half of hospitals’ drug purchases according to one analysis.

This covers most of the big purchases, though far from all of them.

Despite its incredible complexity, the net effect of the variety of U.S. drug purchasing approaches has been effective in incentivizing innovative drugs for some of the most complicated, deadly conditions, including lifesaving HIV/AIDS therapies. That said, there is growing agreement on both sides of the political aisle that our approach may not be sustainable going forward.

So what might be the alternative? Well, if we think that we’re paying “too much” for some drugs, or that the prices aren’t justified, we’re implicitly saying that we’re not getting enough value for the money we’re spending. So naturally, the solution might be to pay for what we want – in this case, value.

But “value,” in the health care system, is somewhat abstract. What value? To whom? And how its measured? are all controversial, unsettled questions. More importantly, how we decide to pay for value in one case, may not apply in another. And even focusing on value may miss other important considerations.

The rest of this post and part two (forthcoming) will address several potential improvements to how we pay for drugs today, with a focus on value.

Innovative Curative Drugs with long payoff periods

Take one of the most controversial pricing debacles in the past few years – Sovaldi. The drug, essentially a cure for hepatitis C, was priced at $84,000 per full course of treatment. When all is said and done, the drug delivers fantastic value, even at the nominally high price. What’s more, the drug actually pays for itself over time due to reduced incidence of hepatitis C, fewer liver transplants, and less reliance on maintenance therapies like interferon and ribavirin.

But even with the discount that Medicaid programs receive (these are likely significant for Sovaldi, because average rebate negotiated by PBMs for the private sector was reportedly around 50 percent), there have been reports of State Medicaid agencies running into budgetary concerns. Some had implemented cost-saving restrictions on who would be allowed to receive the drug (these restrictions were struck down in Washington, however, and likely won’t survive judicial challenges).

The issue with Sovaldi and other highly-effective, curative therapies is less about the nominal price, and more about the effect on budgets. Sovaldi’s “cousin,” Harvoni, for instance, was the top prescribed drug on the exchanges in 2015, according to an Express Scripts report. With around 3 million people with hepatitis C in the U.S., treatment costs for the entire population would be staggering.

But given the enormous benefits of these curative therapies, payment policy should incentivize their development. These aren’t the types of drugs on which we want to risk pushing down the price too far, so that development is not adequately incentivized. Instead, the goal should be to amortize their cost over time – commensurate with the period over which their social benefits accrue.

The details matter a lot here. One approach would be a social investment scheme, similar to the “health care loans” proposed by researchers at Harvard and MIT, for which investors provide the funding mechanism. Public programs like Medicaid might issue bonds against future savings. In any case, not only does an amortization approach help pay for high-value treatments, it also incentivizes their development by assuring pharmaceutical companies that budget constraints will be a lesser issue.

The second post in this series will address two other situations that often arise with drug pricing – innovative (but non-curative) drugs, as well as generic drugs which have been in the news lately. Stay tuned!

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