How Should the Government Negotiate Medicare Drug Prices? A Guide for the Perplexed

Now, at last, thanks to the Inflation Reduction Act (IRA), the federal government will be allowed to negotiate a “maximum fair price” for drugs covered by Medicare Part D. This historical change, taking place in the face of intense industry opposition, incrementally reverses policies that have prohibited the government from engaging in price negotiations since Medicare Part D was first established in 2003. While only ten drugs will be subject to negotiation in the first year of the IRA and 90 over the first five years, negotiations are now ongoing.

The IRA creates a highly scripted process for identifying the drugs that will be subject to price negotiations each year and lists specific factors that may be considered in these negotiations, including the manufacturer’s research and development costs, the returns on these investments, federal financial support for discovery and development, and the extent to which the drug addresses unmet medical needs. However, the Act leaves unsettled how these factors will be weighed by the government in these negotiations.

It has been suggested that the government should negotiate for value-based pricing that would benchmark the Medicare Part D price measures of the health benefit provided to those using these drugs. This would be analogous to the approach currently used by most European countries for drug pricing. We believe this approach is inadequate and fails to provide the public with a return on the massive US government investments in biomedical research related to these drugs that enabled these products to be developed and commercialized in the first place.

Extensive research has demonstrated that the government plays a critical role as an early investor in innovation and that the risk embodied in these investments is not proportional to the public sector returns. For example, our previous studies show that government-funded biomedical research plays an essential role in enabling successful drug development and that investment by the US National Institutes of Health (NIH) in research related to drugs approved from 2010-2019 was comparable in scale to reported investment by industry.

In our new INET working paper, we extend these analyses to the ten drugs selected for Medicare price negotiation in the first year of the IRA. Our analysis reveals that the NIH spent $11.7 billion on basic or applied research related to the drugs selected for Medicare price negotiations, representing a median investment cost of $895.4 million per drug and, by making this research available to industry, saving industry a median of $1,485 million per drug. While data on industry investments in these ten drugs is not publicly available, this level of NIH investment is comparable to reported investment by industry in the drugs approved from 2010 to 2019.

Our analysis also assessed the health benefit (health value) provided to consumers through Medicare Part D spending on these drugs. This analysis involved a review of the published literature on the number of Quality-Adjusted Life Years (QALYs) accruing to individuals using these products and multiplying this measure of value by the number of Medicare Part D beneficiaries who received these products. This analysis showed that eight of the ten products selected for price negotiation (excluding products for diabetes) created a total health value of 650,940 QALYs or $67.7 billion based on estimates of US consumer’s willingness to pay (WTP) of $104,000 per QALY. Our analysis also showed that Medicare Part D spending on these eight drugs was $97.4 billion, resulting in a net negative residual health value (analogous to the consumer surplus) of -$29.6 billion before rebates. While manufacturer rebates on drug sales can be substantial (estimates range from 20-45% from 2017-2021), our conclusion was that there is a negative, or at best, a narrow, margin between the price currently being paid by Medicare Part D and the health value accruing to consumers from this spending.

While benchmarking the price paid by Medicare Part D to the health value created by this spending (i.e., value-based pricing) would rectify any deficit in the balance between price and value, it would not provide for a return on public investment in the discovery or development of these products. That return would require a surplus between the value received by the public and the price paid to producers. In this context, our new INET working paper argues that price negotiations under the IRA need to benchmark the margin between the price paid by Medicare Part D and the health value created – the residual (or net) health value - against the expected return on public sector investment in these products.

Consideration of investment costs, risks, and returns is central to the concept of a “fair price” that can be agreed upon by buyers and sellers. As such, the maximum fair price must be one that provides appropriate returns on both government and industry investment in drugs consistent with the scale and risk of these investments. Moreover, as argued by Lazonick, Mazzucato, and others, these negotiations should recognize the co-creating roles of the public and private sectors in innovation and assure that the returns on public sector investments are comparable to those investments made by the private sector. The empirical analysis of public sector investments and the health value created by the drugs selected for Medicare price negotiations provides a cost basis for such an assessment.