Pharmaceutical cost shifting

Eliminating drug price differentials across government programmes in the USA,” by Kalipso Chalkidoua, Gerard Anderson, and Ruth Faden, explains why and how different US federal health programs pay different prices for prescription drugs. The authors also make the case for eliminating the price differentials. Though that’s the main thrust of the paper, I’m not going to discuss it. Instead, I’d like to highlight their discussion of pharmaceutical cost shifting among government programs.

Cost shifting exists when a firm raises its prices to one buyer because it lowers the price to another buyer (Morrisey December, 1996). Two conditions must hold: (a) the firm has enough market power to cost shift (i.e. there is little or no competition) and (b) the firm has not been fully exercising this power (Morrisey, 2003). Patent protection suggests that the first condition is met. Sole source drugs with no therapeutic substitutes have considerable market power to set the price without significant market constraints (Frank and Newhouse, 2008). For the second condition to apply, drug companies must be currently offering some government agencies lower prices than they could obtain if they were fully to use their market power. In other words, the drug companies are currently not charging the full amount they could to certain government agencies. […]

We examine the empirical evidence of cost shifting or distortionary effects caused by administered prices, in the ‘natural experiment’ that was the introduction of the most favoured customer clause for Medicaid reimbursement of pharmaceuticals (Omnibus Budget Reconciliation Act of 1990 OBRA-90). It has been argued that this policy was directly responsible for higher drug prices for private purchasers, a conclusion often cited as a key reason why government should avoid, in the future, using its bargaining power to get lower prices (Scott-Morton, 1997; Kyle and Ridley, 2007; Hogberg, 2007).

In the early 90s the General Accounting Office carried out two analyses, neither of which supported the cost-shifting hypothesis (Government Accountability Office, 1991, 1993). In 1996, a CBO report attributed the reduction in the number of large price discounts to private purchasers observed after 1991 to Omnibus Budget Reconciliation Act (OBRA’s) inclusion of a provision that guaranteed Medicaid the ‘best price’ obtained in the private sector. However, without data from the period that preceded the legislation, no causal relationship could be credibly established. The analysis also showed that best price discounts health maintenance organizations (HMOs) and hospital groups received from manufacturers were in fact higher in 1994 compared to 1991 for 30% of the drugs reviewed (Congressional Budget Office, 1996).

Two highly cited studies published in 1997 and 2005 claimed that the Medicaid best price provision resulted in higher costs for the private sector (Scott-Morton, 1997; Duggan and Scott-Morton, 2005). The 1997 study concluded that the Medicaid best price provision resulted in a 4% increase across drugstore (but not hospital) non-Medicaid prices for multi-source branded drugs, while it had no significant effect on single-source branded drug prices. The study has severe data limitations and reaches a rather counterintuitive conclusion that the more intense the competition (multi-source drugs) the larger the cost-shifting effect. More importantly, the impact of OBRA on prices, even if causality is accepted, is, at best, modest: a 4% price increase for a small subgroup of drugs studied. Averaged across all branded drugs, the observed rise in price would be much lower than 4%.

The 2005 study showed that drugs popular with Medicaid tended to be, on average, more expensive, which the authors attributed to OBRA. However, the observed trend was not statistically significant at the conventional 5% level. Based on the empirical analyses, the Medicaid best customer clause may have led to a very small increase in non-Medicaid prices. Given the methodological and data limitations and the modest effect size, this finding cannot be used to discourage current thinking on a consolidated government approach to purchasing drugs.

If this is a thorough review of cost shifting in the pharmaceutical sector (and I have no reason to doubt it is not), it’s a rather thin literature. Also, I have not independently studied the papers cited, so I can’t say how good the methods are. But, taking the authors at their word, there does not seem to be much by way of cost shifting. This is not surprising. I more readily believe that pharmaceutical manufacturers are profit maximizers than I do hospitals. As I showed in two prior posts, under a profit maximization hypothesis, cost shifting can’t occur. It seems like the evidence is roughly consistent with this theory.


Congressional Budget Office (1996), How the Medicaid Rebate on Prescriptions Drugs Affects Pricing in the Pharmaceutical Industry. Washington, DC.

Duggan, M. and F. Scott-Morton (2005), The distortionary effects of government procurement: evidence from medicaid prescription drug purchasing. In Working paper.

Frank, R. G. and J. P. Newhouse (2008), ‘Should drug prices be negotiated under part D of Medicare? and if so, how?’, Health Affairs (Millwood), 27(1): 33–43.

Government Accountability Office (1991), Medicaid: Changes in Drug Prices Paid by VA and DoD Since Enactment of Rebate Provisions, Washington, DC.

Government Accountability Office (1993), Changes in Drug Prices Paid by HMOs and Hospitals Since Enactment of Rebate Provisions, Washington, DC.

Hogberg, D. (2007), ‘Letting Medicare ‘‘Negotiate’’ Drug Prices: Myths vs. Reality, National Center for Public Policy research 2007’, MedicareDrugPrices.html [cited April 2008].

Kyle, M. K. and D. B. Ridley (2007), ‘Would greater transparency and uniformity of health care prices benefit poor patients?’, Health Affairs (Millwood), 26(5): 1384–1391.

Morrisey, M. A. (2003), ‘Cost shifting: new myths, old confusion, and enduring reality’, Health Affairs (Millwood), Suppl Web Exclusives: W3-489-91.

Morrisey, M. A. (1996), Employee Benefit Research Institute issue brief.

Omnibus Budget Reconciliation Act of 1990 OBRA-90, Pub.L. 101-508, 104 Stat. 1388. 1990-11-05.

Scott-Morton, F. (1997), ‘The strategic response by pharmaceutical firms to the Medicaid most-favoured-customer rules’, Rand Journal of Economics, 28(2): 269–290.

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