Statement of Michael J. O’Grady, Ph.D., Senior Research Director,
Project HOPE, Bethesda, Maryland

Testimony Before the Subcommittee on Health
of the House Committee on Ways and Means

Hearing on Medicare Payments for Currently Covered Prescription Drugs

October 3, 2002

Madame Chairwoman and members of the Subcommittee, my name is Michael J. O’Grady and I am a Senior Research Director at Project HOPE.  Previously I have served on the professional staff of the Senate Finance Committee, The Bipartisan Commission for the Future of Medicare, The Medicare Payment Advisory Commission and The Congressional Research Service.  In those various roles I have had a chance to extensively study the Medicare program and a number of different health insurance programs, including the Federal Employees Health Benefits Program (FEHBP), the California Public Employees Retirement System (CalPERS) and private sector employer-provided health insurance programs.  I appreciate the opportunity to comment today on the how Medicare’s payments for currently covered drugs might be improved.

Three Key points:

1)    The current payment system is overpaying for the drugs Medicare covers.

2)    The evidence is in from the CMS competitive bidding demonstrations and other insurers that a competitive purchasing of drugs can yield significant savings, without hurting quality or beneficiary access.

3)    A reformed payment system based on competition between drug manufacturers for access to the Medicare market and competition between PBMs to be Medicare’s purchasing agent has the opportunity to provide the highest quality drugs at the most competitive price.

Background:

The Problem:  A basing payment on the average wholesale price (AWP) has long been a problem.  The overpayments associated with the formula are well documented by the Office of the Inspector General (OIG) and the General Accounting Office (GAO).[1]  The vulnerability of the current AWP-based payment formula to gaming by manufacturers has resulted in significant overpayments by Medicare.  Figure 1 provides an example of the problem with the AWP-based formula.  As a general rule, any payment formula that relies on data that cannot be effectively verified, through audits or other means, leaves itself vulnerable to manipulation.
 

Source: “Average Wholesale Price for Prescription Drugs: Is There a More Appropriate Pricing Mechanism?”  Dawn M. Gencarelli, National Health Policy Forum, NHPF Issue Brief No.775 / June 7, 2002, based on information from U.S. General Accounting Office, Medicare: Payments for Covered Outpatient Drugs Exceed Providers’ Cost, September 2001 (GAO-01-1118), Washington, D.C.

The AWP-based formula is a prime example of how hard it is to get administered prices right.  Every year CMS tries to accurately estimate thousands of different prices in thousands of different counties.  This almost Herculean task is very hard to do accurately.

How to Correct the Problem:  Unlike most problems with Medicare payment policy, this problem has a relatively straightforward solution.  The evidence from the CMS competitive bidding demonstrations is in and the results are encouraging.  CMS conducted successful durable medical equipment demonstrations projects in Florida and Texas.  In the San Antonio competitive bidding demonstration, pharmacy suppliers were asked to bid for Albuterol, a drug used for respiratory illnesses with a nebulizer.  Medicare saved an estimated 25 percent over what it would have paid without competitive bidding and there were no discernable effects on beneficiary access (see Table 1).[2]

Outside of Medicare, public and private insurers have made heavy use of pharmaceutical benefit managers (PBMs) to help negotiate discounts and manage benefits.  A recent study found that that PBMs managed 71 percent of insured purchases at retail drug stores in 1999.[4]  The success of PBMs in the Medicare program will depend on the structure and incentives the program provides.  A study by the Kaiser Family Foundation found the potential for PBM’s to provide a cost-effective Medicare drug benefit were significant, if structured properly.[5]

For Medicare to ignore the effective tools used by all other major insurers, both private and public, is inefficient at best and irresponsible at worst.

As the deliberations on a possible outpatient drug benefit continue.  A smarter, more efficient and more flexible CMS is a necessary starting point.  CMS has to move up the learning curve on the smartest, most efficient ways to purchase pharmaceuticals.

What are the essential goals in redesigning Medicare’s drug reimbursement?

1)    Ensure beneficiary quality and access, while being as prudent a purchaser as possible.

The Medicare program has a responsibility to the beneficiaries to provide high quality health care.  The Medicare program also has a responsibility to the taxpayers’ to be as careful as possible with their tax money.  Indirectly the Medicare program has a responsibility to providers.  Like any other insurer, if Medicare treats providers unfairly and pays them less than the cost of providing care, underpayments will eventually result in reduced quality and access for beneficiaries.  Paying providers fairly does not mean overpaying providers.  Given the dangers to Medicare’s financial viability associated with the approaching retirement of the baby boom generation, Medicare must negotiate for the most competitive prices possible and take full advantage of the government’s considerable buying power.

2)    Ensure flexibility and adaptability to change:

If there is any certainty in this policy area, it that things will be in almost constant change.  Any payment policy that is not flexible enough to adapt to those changes runs the risk of overpaying for some drugs, underpaying for others and possibly denying Medicare beneficiaries access to the latest breakthroughs.

Technological change affects payment policy in two key ways: 1) New products are constantly becoming available and 2) The price of established products may change significantly over time.

Whether to cover a particular drug is a decision made separately within CMS.  However, setting the payment is part of the payment methodology and critical in determining how available the drug will be to beneficiaries.  In the case of new, breakthrough drugs still under patent, no insurer is in a very strong negotiating position.  But even patented drugs find themselves in competition with other patented drugs developed by other manufacturers.  Given the serious competition between drug manufacturers there are opportunities for negotiation.  The alternative method of setting a fixed government rate is in effect a “take or leave it” situation, without the flexibility to adapt quickly to an evolving situation.

Over time the price for a particular drug may change significantly and a well-designed payment methodology will take these changes into account.  The clearest example is when a drug comes off patent and generic alternatives become available.  But, even while still patented, the price can change significantly and usually in a downward direction.  There are economies of scale and competition for other patented drugs that reduce the price of a drug. 

The opposite can be true as well.  One of the more interesting results of the CMS competitive bidding demonstrations was that while most prices came down well below the traditional CMS rate schedule, this was not universally true.  There were some products were prices had risen and the CMS administered price was well below the negotiated price.  Perhaps the suppliers were not the effective negotiators they had been on the other products, or perhaps the administered price was too low.  To repeat an earlier point, trying to set an appropriate price without negotiation is extremely difficult.  In the case of Part B covered drugs the evidence points to significant overpayment, but the opposite is also true.  It is just very hard to accurately set thousands of prices in thousands of different counties.  The potential for both overpayment and underpayment is high.

How to achieve these goals?

How can Medicare develop a payment method that will achieve these goals?  An essential design consideration is getting the incentives right.  Use the competitive nature of the industries involved to maximize Medicare’s goals.  Design the payment system, so drug manufacturers, suppliers and providers will be the most successful by providing the high quality products at the most competitive prices.

There are two areas where competition can be used to encourage more prudent purchasing:

1)    Competition among drug manufacturers for access to the Medicare market.

2)    Competition among group purchasers, e.g., PBMs, to supply the drugs to providers.

Competition for access to the market – The California Public Employees Retirement System (CalPERS) is an example of an insurer using competition for access to help control spending.  Due to effective union contract negotiations by the California state employees unions, the state contribution towards an employee’s health insurance was generous, sometimes more than 100 percent of premium costs.  Without some effective method to negotiate, the health plans would have no incentive to ever bid below the state contribution.  Offsetting this disincentive, CalPERS has taken bids from a number of different health care plans, with the understanding that not all plans would necessarily be allowed to offer coverage to the approximately one million state and municipal employees.  The result has been active competition between California health plans to offer the most coverage at the lowest price and premiums below the level of the state contribution. 

Medicare could apply the same method by designing a payment system that has drug manufacturers compete for access to the Medicare market.  This could be done using PBMs or other group purchasing organizations.  PBMs currently negotiate savings with manufacturers based on their ability to purchase in volume.  The PBMs represent a collection of groups, typically employers, who allow the PBMs to negotiate for them.  Failure to reach a successful negotiation with the PBM results in the manufacturers drug not being covered or covered at a higher beneficiary copay.  Medicare can use PBMs or other group purchasing organizations the same way employers do, to negotiate with the drug manufacturers for group discounts. 

Competition to supply providers – A familiar example of this style of competition is the Federal Employees Health Benefits Program (FEHBP).  Insurers compete with one another to enroll workers and retirees in their plans.  The government contribution is fixed as a percentage of the weighted average premiums bid by the insurers, which means insurers with higher bids are more expensive to the workers and retirees.  Premium cost growth is slowed as workers and retirees shop between the plans for the best plan at the most affordable price.

A similar design could be used where PBMs and other group purchasers compete to offer Medicare covered drugs to Medicare providers.  This could be done by having the PBMs bid to participate in the program based on the discounts they already have, or believe the can get, from drug manufacturers.  If there were a number of PBMs or group purchasers negotiating to supply Medicare covered drugs; providers would have the ability to shop between the different suppliers for the best price and service. 

The government payment to providers could be set to the average price of the drug.  The providers would have the ability to choose among the multiple PBMs for the most competitive price and the best service.  By setting the payment to the average price of the drug, the provider is assured that there are PBMs offering the drug at that price, but the provider incentives are to shop for lower cost PBMs within the system.

Concluding remarks:

The best chance of maximizing quality and access, while minimizing Medicare expenditures lies in designing a purchasing system that builds on competition between both manufacturers and PBMs. 

By structuring the competition at two levels and having PBMs and other group purchasers act as intermediaries, the link between drug manufacturer and the providers is effectively broken.  

How the competition is structured is key to the success of the program.  The incentives of all actors, manufacturers, PBMs and providers, have to structured in the same direction – they only gain by providing quality products and service at the best possible price.

[1] Medicare Payments for Covered Outpatient Drugs Exceed Providers’ Cost. Report to Congressional Committees United States General Accounting Office, GAO-01-1118, September 2001. 

[2] “Second Annual Report to Congress: Evaluation of Medicare’s Competitive Bidding Demonstration
For Durable Medical Equipment, Prosthetics, Orthotics, and Supplies.”  U.S. Department of Health and Human Services, Centers for Medicare & Medicaid Services, Baltimore, Maryland, September 2002. http://www.cms.gov/healthplans/research/dmebid.asp

[3] Op. cit., footnote #3, page 4.

[4] “The Role Of PBMs In Managing Drug Costs: Implications For A Medicare Drug Benefit,”  Prepared by: Anna Cook, Ph.D., Thomas Kornfield, M.P.P., Marsha Gold, Sc.D., Mathematica Policy Research, Inc.
Prepared for: The Henry J. Kaiser Family Foundation, January 2000, page 7.

[5] Ibid. page xi.