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The Real Dangers of Medicare
John Calfee, New York Sun, 1-12-07

Last Friday, the U.S. House of Representatives passed a bill requiring the Secretary of Health and Human Services to negotiate drug prices for medicines covered by the Medicare drug benefit—but it also forbade the Secretary from creating a formulary of covered drugs.

In this article, Calfee explains why the lack of a formulary in the House bill may—if it eventually becomes law—unleash a cycle of cynicism about drug pricing that will lead to explicit price controls and reduced medical innovation. it happens, the [Medicare] drug benefit has worked far better than almost anyone expected, with drug prices at or near the bottom of those in the private sector, coverage at 90% as opposed to 55% in 2002, an over 80% satisfaction level, and unexpectedly low government costs. Just last week, CMS revised downward by $113 billion, a remarkable 11%, its 10–year estimate for the total cost of the drug benefit, not long after announcing that in 2007, as in 2006, insurance premiums would be roughly two–thirds of the level that was predicted when the program was designed.

But the Democrats still don't like that noninterference clause [in the Medicare drug benefit]. They believe their bill would give CMS the bargaining power that Canadian and European governments use to obtain below–market prices through government price controls.

But there's a problem: formularies, or more precisely, their absence. Drug formularies dictate which few brands are reimbursed in each therapeutic class and which are left out, the latter for which beneficiaries pay much higher prices. For example, a plan might pay only for generic Mevacor or Zocor among cholesterol–reducing drugs, forcing patients to pay full–market prices for more potent drugs like Lipitor and Crestor. The drug benefit law banned national formularies because Congress knew that Medicare beneficiaries would be upset to discover that some of their favorite drugs were not covered.

The Democrats plan to keep the formulary ban in place. That's a big problem. CMS would negotiate prices with sellers who know CMS has to buy essentially every significant brand in every therapeutic class. So where is its bargaining power? Any number of economists, including the Congressional Budget Office in a letter released on January 10, have pointed out that wherever you find sub–market drug prices, you find some type of formularies.

Although there are no national formularies in Medicare Part D as it works now, the various competing insurance plans have plenty of formularies. The plans with narrower formularies tend to have better prices. Or consider the Department of Veterans Affairs. This is the Democrats' model for price negotiations, but they have ignored the fact that the VA maintains notoriously narrow formularies.

In Europe and Canada, it's the same story: Formularies or the threat of formularies are what drives price negotiations...

But that is far from the end of the story. The Democrats obviously expect CMS to use other tools, most notably the preferred list. Like Medicaid, CMS could probably maintain a list of favored brands available at low prices, leaving other drugs with high co–pays unless the doctor obtains special permission from CMS to prescribe the drug. Experience has shown that preferred lists are nearly as powerful as formularies. The drug manufacturers could then retaliate by advertising directly to patients about the advantages of drugs left off the preferred list. That would stir the political pot considerably.

This entire episode is best understood as a starting point in a dangerous new dynamic. The real threat is that the Democrats' fix for something that "ain't broken" will either create irate beneficiaries facing formulary–like restrictions or fail to bring dramatically lower drug prices. Disappointment will generate intense political pressure to attack prices directly, not just in Medicare but in the private sector as well. The entire panoply of price controls, including explicit price ceilings will come into play.

The adverse consequences will be enormous. The dark process of sending powerful anti–innovation signals to the pharmaceutical industry will begin, ironically at a time when cancer, Alzheimer's, and other vicious diseases are finally starting to succumb to one of the great spates of freewheeling risk–taking and profit–seeking in the history of technological advance. This is the real danger from recklessly undermining what is left of a free market for health care technology.

Project FDA.
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