Medicare’s Structure and Payment Systems Part III: Prescription Drug Plans

This post originally appeared on The Finance Buff.

This is the third and final post on the basics of Medicare’s structure and payment systems. The two prior posts in the series covered fee-for-service (FFS) Medicare (post I) and Medicare Advantage (MA) (post II). In this post I focus on the relatively new Medicare outpatient prescription drug benefit, Medicare Part D.

Part D Basics

The Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (MMA) added an outpatient prescription drug benefit to Medicare (Part D), starting in January 2006. The highly subsidized benefit is available exclusively through private insurance plans, either MA plans offering bundled Part A (hospital) and Part B (outpatient) insurance along with a drug benefit or stand-alone prescription drug plans (PDPs) that offer no non-drug coverage (i.e., they complement FFS Medicare).

Medicare Part D accounts for 12% of Medicare spending, and about 60% of Medicare beneficiaries are enrolled in a Part D plan. Most enrollment in Part D plans (72% of it) is in PDPs. While I will focus more on PDPs below, the drug benefits available through MA plans are identical in structure and share the same payment system as PDPs.

PDPs serve multi-state regions, of which there are 34. Each region has at least 45 PDPs offered in 2009. Part D plan benefits take two fundamental forms: basic or enhanced. Basic coverage either follows a statutory minimum standard or is actuarially equivalent to it, while enhanced coverage offers additional benefits for a higher premium. Standard coverage has an average monthly premium of about $34 (in 2009) and is designed so the average beneficiary pays, at most, 25.5% of the cost of coverage, while Medicare pays the remaining 74.5%.

Standard coverage cost sharing is characterized by different coinsurance rates in each of four ranges of total drug spending (the sum of spending by the plan and beneficiary). In 2009 the standard benefit cost sharing is: 100% coinsurance for drug spending between $0 and $295 (i.e. a $295 deductible), 25% coinsurance for drug spending between $295 and $2,700, 100% coinsurance for drug spending between $2,700 and $6,154 (the so-called “donut hole” or “coverage gap”), and 5% coinsurance for drug spending above $6,154 (catastrophic coverage). These dollar amounts are indexed to average per beneficiary outpatient drug expenditures (MMA statute).

Part D Competitive Bidding

In contrast to the way in which MA plans are paid for Parts A and B (see my MA post), Part D benefits are paid by Medicare via a competitive bidding system. All Part D plans (PDPs and the drug portion of MA plans) submit bids for the cost of standard coverage. From these bids a nationwide average is computed and a statutorily determined fraction of this average cost is set as the “base premium” (about $30 in 2009). Finally, a plan’s premium (charged to each enrolled beneficiary) is the base premium plus the difference between that plan’s bid and the national average bid.

Ignoring adjustments for beneficiary risk and other details (found here) a plan is paid by Medicare a fixed monthly per-beneficiary rate equal to the national average bid less the base premium. Because the payment is tied to national average bids (a market signal) this is a form of competitive bidding. In contrast, MA payments are not set competitively. They are set via administrative pricing in which payments are determined by Congress. The Part D competitive pricing mechanism theoretically should drive payment downward as plans compete to offer lower-premium plans.

The Drug Negotiation Controversy

Part D plans may negotiate with drug manufacturers for volume discounts, but Medicare as a whole may not. This prohibition on direct Medicare-drug manufacturer negotiation was among the more controversial aspects of the Part D program and has received considerable attention from policy makers and academe.

Another related element to Part D is that plan formularies have inclusion requirements. In particular, they must include “all or substantially all” drugs in six categories: antidepressants, antipsychotics, anticonvulsants, antiretrovirals, immunosuppressants, and antineoplastics.

Critics argue that Medicare’s lack of authority to negotiate drug prices leads to higher expenditures for plans, beneficiaries, and Medicare. Others have pointed out that providing Medicare the authority to negotiate directly with manufacturers would not lead to price reductions on its own. To achieve savings Medicare would also need the ability to exclude drugs from its formulary. This ability to tighten the formulary would provide the leverage to negotiate bargains.

Interest remains among policy makers and certain advocacy groups in reducing Medicare drug prices. This idea is part of President Obama’s agenda so the issue may arise as he looks for ways to finance health reform.

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