Drug Prices: A New Covenant?

The states' growing negotiating clout with Big Pharma raises crucial questions

With drug costs soaring, anyone who manages to rein them in will be hailed as a hero. There is no lack of contenders. The latest effort: On Apr. 22, Michigan and four other states won the blessing of the Health & Human Services Dept. to band together and use their combined clout to force pharmaceutical companies to cut prices for their 900,000 Medicaid recipients. Minnesota joined on Apr. 27, and other states are plotting to pile on.

The scheme is expected to save each state millions of dollars. But more important, with the new Medicare drug benefit for seniors looming, it raises a crucial question: By using their combined negotiating power, will large buyers' groups have the power to tame drug costs? The short answer: Yes, prices overall should come down, as they squeeze the pharmaceutical industry. On the other hand, people without drug coverage could pay even higher prices than they do now. Here's why:

How will the states' program work?

Basically, by threatening to promote one company's drugs over another's. Since doctors have many choices of medicines to treat common conditions such as high blood pressure and elevated cholesterol, states can encourage them to prescribe just those drugs whose makers offer the lowest price. States are already doing this individually, getting price breaks -- or, more precisely, rebates off the retail price -- of 12% or more. Banding together will give them even more power, assuming each state will agree to the same list of preferred drugs.

Can't private insurers and pharmacy benefit managers (PBMs) do the same?

Yes. They already do negotiate discounts. One of the sad ironies of our health-care system is that patients with drug coverage get drugs that cost them and their insurers up to 20% less than the prices paid by those who can least afford it -- those without insurance coverage.

Since 120 million Americans have some drug coverage, why can't insurers and PBMs negotiate even deeper discounts?

Buyers' bargaining power depends on their ability to steer patients to particular medicines -- rewarding a maker that offers bigger rebates with a larger market share. Americans don't like being told to use one drug instead of a competitor, so most drug plans aren't very restrictive. Instead, private plans use incentives, like lower co-payments on favored products.

In addition, well-meaning federal laws intended to reduce government costs have had the effect of raising prices elsewhere. A 1990 measure required companies to give state Medicaid plans a minimum of a 15.1% discount from a government-calculated wholesale price. That means Medicaid pays about 60% of the retail price. A 1992 law created even larger discounts for the Veterans Administration and other agencies. The VA also negotiates with companies to wrest even lower prices.

So far, so good. But the 1990 law also requires any drugmaker who offers private buyers a greater discount than Medicaid normally gets to offer that same "best price" to the government program. That gives Big Pharma a powerful disincentive to offer low prices to other buyers. Before the laws passed, discounts to private purchasers averaged 36% off wholesale prices, compared with the mandated 15.1% discount from wholesale Medicaid was then getting. Rather than reduce prices for Medicaid, within three years the industry simply cut the discount for private payers to just 16%. The laws "stifled the discounting and rebating that had been going on before," says consultant Eugene M. Kolassa, author of Elements of Pharmaceutical Pricing. Essentially, efforts to cut drug costs for government buyers ended up raising prices for everyone else.

Will that also happen in 2006 when the Medicare drug benefit kicks in?

Yes, but many more people may get lower- priced drugs, thanks to the bill. While the law specifically prohibits the government from negotiating prices, it increases the clout of the PBMs who will administer the plans for the Medicare to do so.

Private insurers can limit the choice of drugs to as few as two for each class. Given a stark choice -- become one of two players in a huge market, or be shut out -- drugmakers could cough up price cuts of 50% or more, some experts predict. Moreover, the Medicare price doesn't trigger Medicaid's "best price" rules. Low prices for Medicare won't result in lower prices for Medicaid, so drugmakers don't have to worry about taking another hit. Indeed, prices for everyone else -- including Medicaid -- will probably rise. If drugmakers get squeezed on Medicare, they will hike prices for other segments of the market, driving up the wholesale price used to calculate Medicaid's discounts, predicts industry lawyer William von Oehsen of Powers Pyles Sutter & Verville in Washington.

Will the drug industry see lower profits?

Possibly. While prices for some customers -- mostly patients without insurance -- could rise, the average price of drugs across all markets should drop. Some analysts predict that the Medicare drug benefit will induce Americans to use a lot more drugs, generating enough new sales to offset the lower revenues per drug. But others doubt that sales will increase that much.

The industry claims lower prices and profits will cut research funds needed to create breakthrough drugs. Is this true?

Not really. Yes, the new state plans and the Medicare bill will give private insurers and states more negotiating clout -- but mostly when several similar drugs exist. When drugmakers come up with valuable new drugs that have no rivals, they'll still command top dollar. "This kind of pricing puts even greater pressure on us to be first with novel medicines," acknowledges Ian D. Spatz, head of public policy at Merck & Co. (MRK ).

What's the bottom line?

The drug market in the U.S. is a convoluted mess, with prices all over the map. Laws and regulations often make things worse instead of better. But market forces increasingly are at work. The good news should be lower average prices and greater incentives to focus R&D on drugs that really matter. Unfortunately, though, prices for the uninsured will likely continue rising.

By John Carey in Washington, with Amy Barrett in Philadelphia

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