Department of Health and Human Services (HHS) Secretary Alex Azar released a proposed regulation earlier this month to roll back the practice of rebates in the pricing of prescription drugs in Medicare Part D and Medicaid managed care programs. Sec. Azar and others in the department have made the elimination of rebates paid by manufacturers to pharmacy benefit managers (PBMs) and health plan sponsors a key part of their overall effort to ease pressure on drug prices.

The administration argues that rebate payments have a pernicious effect on the pharmaceutical market by providing an incentive for PBMs to favor high list prices combined with large rebates, rather than negotiating low list prices without rebates. PBMs have gained financially from the rebate system. The Altarum Institute estimates that PBM revenues included $89 billion from rebates.

Drug manufacturers are willing to pay rebates to secure favorable positions on drug formularies. Preferred drugs are typically assigned to a lower tier with lower cost-sharing amounts. That incentive helps steer patients to preferred drugs, and greater sales volumes increase the amount of rebates collected from the manufacturers.

Reliance on rebates rather than upfront price discounts lowers the net price paid to the pharmaceutical manufacturer, but that reduction may not be reflected in what the consumer pays at the pharmacy. Many patients pay a percentage of the list price rather than the price net of rebates.

There is evidence that PBMs have favored rebates over lower list prices in the Medicare Part D drug benefit. That may not be the result of a fundamental distortion in the market that requires corrective regulatory action by the government. It is possible that the trend toward rebating has more to do with the design of the Medicare drug benefit itself.  In 2016, drug manufacturers paid rebates to private insurers serving the job-based and individual markets equal to 12 percent of the prices charged at pharmacies, which is far less than the 20 percent (and growing) rebate rate found in the Medicare Part D program.

The administration argues that a ban on rebates would produce better market results but there is no concrete evidence backing up this claim. The effects of the policy on prices and spending would depend on how the various parties respond to the new rules. The best available analysis, produced by the government’s own actuaries, suggests that the new policy might increase, rather than decrease, Medicare spending. At a minimum, this policy should be examined much more thoroughly before it is promulgated as a final rule.

The Administration’s Proposal

The federal Anti-Kickback Statute, enacted in 1972, criminalized offering or accepting payments to induce use of services reimbursable under federal health-care programs–including Medicare and Medicaid. The Medicare and Medicaid Patient and Program Protection Act of 1987 requires HHS to establish “safe harbor” protection for certain practices that are common in the industry and should not be precluded by the anti-kickback law. Rebate payments from drug manufacturers to PBMs and health plan sponsors are among the practices currently protected by the safe harbor regulations.

The new rule would revoke that protection for price reductions offered by drug manufacturers to PBMs, Medicare Part D plan sponsors, and Medicaid managed care organizations. In its place, a new safe harbor would allow manufacturers to offer point-of-sale discounts to PBMs based on considerations similar to those used to set rebates (such as placement of the drug on a PBM’s formulary or the volume of sales through the PBM).

HHS expects that the pharmaceutical industry would shift from rebates to up-front price negotiations, affecting transactions across the market. Although negotiated discounts would result in point-of-sale price concessions, there is nothing in the regulation requiring manufacturers to offer price discounts that are equivalent to the rebate payments currently going to the PBMs.

OACT Estimate

The Office of the Actuary (OACT) in the Centers for Medicare and Medicaid Services estimated the impact of the proposed rule on Medicare (including Part D and Part B drugs), Medicaid, and the private health insurance market. Although the regulation would not directly change requirements in the private market, OACT assumed that there would be indirect effects. By far the greatest impact would be seen in Part D.

Eliminating rebate payments in Medicare Part D would lead to adjustments by manufacturers and PBMs, affecting Part D premiums and cost-sharing paid by patients at the pharmacy. OACT assumes that drug manufacturers would retain 15 percent of the rebate payment they currently send to PBMs. The actuaries expect the other 85 percent would be divided between lower list prices (21.25 percent) and point-of-sale discounts (63.75 percent).

With the loss of rebate revenue, premiums for Part D plans would increase, with beneficiaries paying about 25 percent of that increase and taxpayers covering the rest. Medicare beneficiaries, especially those who purchase relatively expensive drugs, would pay less in cost-sharing because the list prices and the point-of-sale prices would be lower.

Based on those assumptions, OACT estimates that the new policy would substantially increase federal spending for prescription drugs over the next decade. Their bottom-line findings are noteworthy:

• Economy-wide spending on prescription drugs would increase by $137 billion over ten years. Put another way, the drug manufacturers would see a sizeable increase in their overall sales revenue.
• Federal spending in Medicare would increase by $196 billion over ten years. With higher Part D plan premiums, the federal government would spend an additional $274 billion over ten years for premium subsidies (including premium subsidies for low-income enrollees). That added spending would be partially offset by lower reinsurance payments by the government, which compensate Part D plan sponsors for costs associated with larger than average numbers of high-cost patients, and by lower spending on cost-sharing subsidies for low-income enrollees.
• Medicare beneficiaries would spend $83 billion less on prescription drugs over ten years but $58 billion more for Part D premiums, for a net saving of $25 billion. Most Medicare beneficiaries would see an increase in their costs because higher premiums will outweigh their reductions in out-of-pocket spending for drugs. Beneficiaries needing high-cost drugs would see sizeable reductions in their spending. On average, beneficiaries would spend slightly less than they do today under Part D. The average per capita savings would be about $30 in 2020 and $540 over ten years.
• Drug manufacturers would spend nearly $40 billion less on discounts required for products sold to beneficiaries who are in the Part D coverage gap.
• The change in the weighted average net price for a drug would depend on several factors, included the share of sales occurring in Medicare Part D versus the private market. If a product’s sales are split 45 percent in Medicare Part D and 55 percent in the private market, the weighted average price would increase slightly.

Other Estimates

HHS’s Office of the Assistance Secretary for Planning and Evaluation (ASPE) commissioned two actuarial studies of the effects of ending rebate payments. The studies by Milliman and Wakely focused on the impact on stakeholders in Medicare Part D.

The Milliman study estimated how spending would change based on how drug manufacturers might alter their pricing in response to a rebate ban. In a scenario that assumes drug companies pass along 80 percent of current rebate payments in the form of lower list prices or point-of-sale discounts, total Medicare spending would increase by $135 billion over decade. That is similar to OACT’s estimate.

Milliman also estimated scenarios in which PBMs respond to the loss of rebates with more restrictive formulary designs, which force drug companies to offer lower net prices than are implied by the current rebate system. Separately, under an assumption of aggressive negotiation over pharmacy rebates in the absence of manufacturer rebates, Medicare spending would be reduced by $188 billion over ten years. Milliman provides no evidence to support the assumption that PBMs might gain leverage by negotiating with pharmacies rather than directly with manufacturers.

Unlike the Milliman study, Wakely’s analysis assumes the Part D plans would not change their formularies and 100 percent of current rebate payments would reduce the cost of drugs at the point of sale. Total program spending is estimated to increase by about 3 percent in 2020 if rebates are eliminated from the Part D program.

Part D’s Design Misaligns Incentives

Banning rebates in Part D would provide some financial relief to Medicare beneficiaries, particularly those with high drug needs, at a high cost to taxpayers. But that proposal fails to address flaws in Part D’s design that increase program spending and expose beneficiaries to the risk of high out-of-pocket costs.

Medicare provides Part D plans with a subsidy intended to cover 74.5 percent of program spending. That subsidy is provided in two forms: a direct premium subsidy paid on a per-enrollee basis and individual reinsurance to cover the costs of drugs for high-expense patients. The reinsurance subsidy covers 80 percent of drug spending above a catastrophic threshold ($5,100 in 2019). Part D plans are responsible for 15 percent of those costs, and enrollees pay the remaining 5 percent.

This approach was adopted to ensure that Part D plans would enroll beneficiaries with high drug costs. However, reinsurance reduces incentives for plans to manage costs above the catastrophic threshold. As a result, Part D has experienced a dramatic shift in federal payments from the direct subsidy to reinsurance.

Exhibit 1 shows the changing mix of federal spending on the Part D benefit. In 2008, the direct premium subsidy was $687 per enrollee and reinsurance payments averaged $366 for costs exceeding the catastrophic expense threshold ($4,050 in 2008). As high-cost cases increased and the cost of reinsurance grew, the direct premium subsidy had to be reduced to ensure that the average subsidy per enrollee remained at 74.5 percent of program spending. By 2017, the direct premium subsidy had fallen to $353 while reinsurance payments had risen to $874 per beneficiary. The program is steadily transforming into one in which the federal government is paying for the drug expenses of patients with high annual costs.

Exhibit 1: Medicare Part D Expenses Per Enrollee: Direct Subsidies vs. Reinsurance Payments

Because the federal government is covering so much of the expense above the catastrophic threshold, Part D plans have strong incentives to negotiate larger rebates rather than lower up-front prices. Rebates reduce the net price of prescriptions to the plan, with some of the savings used to keep premiums low. That helps the plans remain competitive and better able to attract more enrollees.

Exhibit 2 shows the impact of those incentives on the growth of rebates in Part D. In 2008, rebates from manufacturers equaled around 10 percent of total Part D costs. By 2027, Medicare’s actuaries expect rebates to exceed 28 percent of total Part D spending.

Exhibit 2: Manufacturer Rebates As A Percentage Of Medicare Part D Spending

Toward An Evidence-Based Policy

The Trump administration argues that the rebate system is a cause of price pressure in the pharmaceutical sector. But the rebate system was created to secure lower, not higher, net prices for drugs. Rebates were a convenient and efficient way for health plans (and their associated PBMs) to use the leverage that comes with pitting one drug against others in a formulary to secure discounts tied to volume. Manufacturers are willing to pay larger rebates in return for enhanced market share.

It is counterintuitive to expect that eliminating this longstanding market tool will necessarily produce lower net prices for consumers. Banning rebates would help patients who are paying cost-sharing based on list prices because the list prices are set high to make room for large rebate payments. But it does not follow that overall drug spending will decline, or that prices paid by the average consumer will fall.

It is tempting to blame high prices on unnecessary middlemen, but those middlemen have been hired by employers and health plans with the expectation that they will be effective at holding down overall costs. Undercutting the ability of PBMs to secure rebates would shift power and leverage to drug manufacturers. It is hard to see how taking that step would lead to lower overall costs for consumers.

The cost estimate from OACT confirms that a rebate ban is just as likely to lead to higher net prices as well as an increase in total spending on prescription drugs. It would be ironic if one of the administration’s first major policies on drug pricing increased overall costs for the average American consumer and taxpayer. That is a real possibility with the administration’s current proposal.

A better approach would address the most obvious source of today’s distorted incentives. Medicare’s Part D benefit design encourages PBMs and health plans to favor larger rebates over lower list prices because most of the cost of high-priced drugs is paid for by taxpayers and not by the plans.

The solution is to redesign the Part D benefit, as has been proposed by the Medicare Payment Advisory Commission and the Trump administration. Last year, Milliman estimated the effect of various options that would cap beneficiary out-of-pocket spending and increase the responsibility of Part D plans to cover the costs of high-cost drugs. Depending on the behavioral responses to these changes, it is possible that a reformed program would produce lower costs for beneficiaries and the federal government.

The status quo is not acceptable. Drug prices in many instances are far too high, for a variety of different reasons. While reform is necessary, poorly considered changes could lead to unintended consequences. Before the Trump administration’s proposed ban on rebates is finalized, Congress should insist on a thorough and independent review of the policy by the Congressional Budget Office. Congress should also assert its role in writing new rules for the marketplace. The starting point should be a redesign of the Part D benefit to provide better incentives for lower prices for high-cost drugs. Such a reform might produce better results than an ill-advised ban on all rebates.

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