Third party payers lead to prices 400% higher than what’s necessary

Drive Up Drug Launch Prices?” https://faculty.fuqua.duke.edu/~dbr1/research/Medicare-drug-prices.pdf

Governments and private insurers reimburse health care providers (physician clinics and hospitals) for drugs they administer, such as drugs used in chemotherapy. The amount that an insurer reimburses a provider typically differs from the price the provider pays the manufacturer (Figure 1). The manner in which Medicare reimburses providers affects the drug’s demand and price. We estimate that a 2005 change in reimbursement caused a more than 400% rise in launch prices for drugs administered by providers. Before 2005, Medicare paid providers an amount largely unrelated to the actual price. Medicare reimbursed providers based on AWP which officially stood for average wholesale price, but which was widely known as “ain’t what’s paid.” Beginning in 2005, Medicare reimbursed providers based on average sales price (ASP) (Jacobson et al., 2010; Yurukoglu et al., 2017). ASP is the average price of purchases made by providers in the previous six months. Hence, in 2005 reimbursement changed from an amount unrelated to the actual price to an average of lagged prices. When insurers reimburse providers based on lagged prices, manufacturers choose a higher launch price for two reasons. The first reason is straightforward: providers are less sensitive to the price when reimbursement covers a portion of the price. The second reason is subtle. A provider’s current reimbursement depends on past prices. Hence, while a provider prefers low current prices, the provider prefers high past prices, because the insurer pays the provider more when past prices are higher. Hence, firms “invest” in a high launch price, higher than the profit-maximizing current price, in order to secure higher reimbursement for the provider in the future. By setting a higher launch price, the future reimbursement is higher, so future demand is higher, and the firm can charge a higher price in the future. We illustrate these effects using a model of reimbursement in a market with rising willingness to pay. We look for evidence of drug launch price increases using a difference-in-differences framework. We compare drug launch prices before and after the 2005 policy change, and we compare launch prices for the treatment and control groups. The 2005 policy change affected drugs administered by providers in an outpatient setting. Hence, the treatment group includes the drugs that health care providers administer to patients in an outpatient setting. The control group includes prescription drugs sold in the retail market. In a robustness check, the control group consists of provider-administered drugs that Medicare excluded from the change in reimbursement. Provider-administered drugs are typically in liquid dosage form (measured in milliliters) because providers inject or infuse the drugs. These drugs go directly into the blood so sterility is critical. Manufacturing standards imposed by companies and the Food and Drug Administration (FDA) are costly. To be consistent, we include only liquid dosage forms in both the treatment and control groups. By doing so, we can be confident that changes in manufacturing costs are not driving rising launch prices for the treatment group alone. Average launch prices could also rise if a higher share of drugs are novel, so we include an indicator variable for whether the drug is a new molecular entity, rather than a variation on an existing drug. Furthermore, average launch prices could rise if drugs have little competition, so we control for competition. Finally, average launch prices could rise if a greater share of drugs are in high-value drug classes, so we include drug class fixed effects. We also include year fixed effects to account for other changes over time. We estimate that a 2005 change in reimbursement policy caused launch prices for outpatient drugs to increase more than 400%. We show that outpatient drug launch prices have risen sharply while retail drug launch prices have changed little (Figure 2). We recommend replacing price-based reimbursement with reimbursement based on value. For example, Medicare could reimburse based on a drug’s quality-adjusted life years added relative to the standard of care.