Last year, President Joe Biden signed into law the Inflation Reduction Act (IRA), setting into motion a series of changes to the way that Medicare and its beneficiaries pay for prescription drugs. Much has been written about the act’s individual provisions, but little has been said about how they fit together as a whole. In fact, these seemingly standalone reforms act together to reshape access and affordability of branded prescription drugs under Medicare Part D, while also leaving the door open to further reforms.
At the center of this framework is a policy to limit beneficiary cost sharing to no more than $2,000 per year. This reform responds to the erosive effect that high prices of drugs set by manufacturers—known as list prices—have had on affordability even with insurance coverage. Because Medicare currently covers 80 percent of spending past a certain threshold, the cost-sharing cap is paired with three additional reforms to ensure that the program remains sustainable: a shift in the allocation of financial risk to manufacturers and industry under the Part D benefit structure, the creation of a program under which Medicare negotiates what it pays for certain drugs, and rebates to claw back spending attributable to drug price growth exceeding inflation. The act includes a fifth provision that caps growth in beneficiaries’ share of Part D premiums at 6 percent, to allow time for savings from these changes to go into effect without impacting premiums.
Cost Sharing’s Burden On Medicare Beneficiaries
The provision to cap beneficiary cost sharing at $2,000 per year, adjusted for inflation, responds to the fact that rising list prices have made drugs increasingly unaffordable to those filling prescriptions. Both the current and redesigned Part D benefit include a component of patient cost sharing, either as a copayment or co-insurance, which is based on list prices. This arrangement harnesses cost sensitivity to steer beneficiaries toward or away from certain drugs depending on their clinical benefits and costs. In many instances, however, patients may choose to discontinue treatment, skip doses, or not fill their prescriptions.
Medicare beneficiaries have been particularly exposed to unaffordable cost sharing because, unlike most commercial health plans, there is no annual limit to their spending on prescription drugs. The current design of Part D leaves them responsible for 5 percent of a drug’s list price even after they have exceeded their deductible and two initial coverage phases in which cost sharing is 25 percent. Most beneficiaries don’t spend enough to qualify for this phase of the benefit, known as the catastrophic phase; some are protected by income-based subsidies. However, those with high spending and without such subsidies can face serious financial consequences. In 2019, 1.5 million Part D beneficiaries qualified for the catastrophic phase of the benefit, with their cost sharing totaling $1.8 billion. Both the number of beneficiaries who enter the catastrophic phase and their cost-sharing burden continue to grow.
Understanding The Drivers Of High List Prices
Implemented as a standalone provision, the cap to beneficiary cost sharing would result in higher overall Medicare spending, both because cost-sensitive beneficiaries would fill more prescriptions and because Medicare covers 80 percent of spending in the catastrophic phase. This insulates plan sponsors and manufacturers from financial liability for high list prices. To prevent ballooning spending, the cost-sharing limit is accompanied by the three provisions mentioned in the introduction, which reform how drugs are paid for under Part D.
Understanding how and why these provisions work requires a sense of the dimensions of the US pharmaceutical market. Approximately 80 percent of prescriptions dispensed in the US are for generics. The remaining 20 percent are for branded drugs that account for 80 percent of spending. Closer examination reveals that, even among these drugs, spending is concentrated among a small number of high-price branded products. Despite accounting for fewer than 1 percent of prescriptions, drugs in the top decile by price account for 15 percent of prescription drug spending. Spending attributable to high-price branded drugs has largely offset Medicare savings from generic drugs.
It’s a mistake, however, to assume that high-price branded drugs are expensive for the same reason. In the case of drugs covered under Medicare Part D, both competition and its absence encourage high list prices. The paradox is rooted in how prescription drug benefits are designed and administered. Health plans that cover prescription drugs, including Part D, use formularies that determine which products are covered, how much beneficiaries pay for them, and whether they must try other drugs first. The manufacturers of drugs with close therapeutic substitutes compete to gain placement on such formularies by providing rebates to the plans and third parties administering the formularies, known as pharmacy benefits managers. To make headroom for greater net price concessions, drug manufacturers often raise list prices. Part D plan sponsors use rebates to keep premiums low but base cost sharing on list prices, driving up expenses for beneficiaries filling prescriptions.
Meanwhile, list prices are also high among branded drugs that are protected from competition, either because they have no therapeutic alternatives or because they are included in a protected class, a group of drugs that Part D plans must cover and includes treatments for cancer and HIV. Because coverage of such drugs is guaranteed in Part D, their manufacturers are free to act as monopolists, with little incentive to offer low list or net prices.
In other words, the drivers of high list prices among prescription drugs are two different, albeit related, issues—a failure to link competitive pressure to list prices on the one hand and an inability to exert purchasing power on the other. The IRA contends with these issues through two key reforms: re-aligning the financial interests of Part D plans and manufacturers to increase their sensitivity to high list prices, and aggregating purchasing power under Medicare to negotiate prices where the plan sponsors cannot.
Addressing High List Prices Driven By Competition
As currently designed, the Part D benefit allows both plan sponsors and manufacturers to benefit from high list prices by shifting financial liability to the Medicare program in the catastrophic phase. Plans are responsible for 75 percent of spending beyond the deductible, known as the Initial Coverage Limit (ICL). Spending above a further threshold enters the Coverage Gap Discount Program (CGDP), or “donut hole,” at which point drug manufacturers are obligated to cover 70 percent, while plans are liable for 5 percent. Once spending continues beyond a third threshold, into what is known as the catastrophic phase, Medicare assumes responsibility for 80 percent of spending, while plans assume 15 percent.
Medicare’s open-ended financial liability in the catastrophic phase has long been criticized for insulating plan sponsors and manufacturers from financial downsides of high spending, creating situations in which high prices may actually act as a reward when paired with high rebates. The IRA confronts this problem by shifting the financial risk in the catastrophic phase toward plan sponsors and manufacturers and eliminating the CGDP entirely. With the change in design, 65 percent of costs in the ICL will fall to plan sponsors and 10 percent to manufacturers. In the redesigned catastrophic phase, Medicare’s share of spending falls to 20 percent, with manufacturers being responsible for another 20 percent and health plans for the remaining 60 percent. Beneficiaries remain responsible for 25 percent of spending in the ICL but will owe nothing in the catastrophic phase due to the cap on cost sharing. Although the redesign comes at a price tag of $25 billion in federal spending, the changes in financial liability can be expected to soften the value of rebate dollars relative to list price reductions.
Addressing High List Prices Driven By Monopoly Power
The IRA also establishes a program under which Medicare will negotiate with manufacturers what it pays for certain branded drugs. Drugs that qualify for negotiation must have been on the market for at least 7 and 11 years, for small molecule and biologics, respectively. This policy responds to the fact that manufacturers have increasingly harnessed intellectual property and market exclusivity protections to protect their most lucrative drugs from generic or biosimilar competition for extended periods of time.
Each year, Medicare is directed to rank such products according to their gross spending in Medicare Parts B and D. A certain number of drugs from the top of the list will then be selected for negotiation, with the goal of arriving at a “maximum fair price” or MFP, which becomes Medicare’s reimbursement rate. Medicare cannot agree to an MFP that is higher than a statutorily defined ceiling: either a percentage of a drug’s cost to non-federal purchasers or the net price achieved by Part D plan sponsors, whichever is lower.
While both drugs with and without branded therapeutic alternatives can be selected, it is among those without close substitutes and with coverage guarantees that negotiation promises the greatest savings. The statutory price ceilings allow negotiations to arrive at prices that would otherwise be expected from generic or biosimilar competition, commensurate with the amount of time the drug has been on the market.
The Congressional Budget Office (CBO) estimates that negotiation will save $101 billion over the coming decade, which is largely due to the fact that Medicare will have leverage to match that of manufacturers. Unlike current circumstances, in which neither Medicare nor plan sponsors is able to decline coverage for certain drugs, the new law imposes restrictions that automatically go into effect should manufacturers attempt to evade negotiation once selected for it. Manufacturers that refuse to participate in the process or delay the negotiation of an MFP past its statutory deadline will be faced with a choice between accepting an excise tax on US sales, which escalates to an onerous 95 percent over time, or withdraw its products from coverage by federal programs.
Safeguarding List Price Reforms Through Inflation Rebates
Although Medicare negotiation and the redesign of Part D address high list prices, as explained above, they do not insulate the program from the well-documented manufacturer strategy of raising revenues by systematically raising list prices, a major contributor to the growth in Medicare spending on prescription drugs. Manufacturers set and raise list prices for the entire US market, not just Medicare, so inflationary pressures on list prices will continue despite reforms. Manufacturers that expect to be selected for negotiation may also raise their list prices in attempts to inflate the price benchmark used in negotiation.
The IRA accounts for this issue through a provision known as the “inflation rebate,” which claws back Medicare spending attributable to list price increases beyond the rate of inflation. The overall effect of the rebate is to make list prices increases less lucrative. The CBO estimates that the federal government will save more than $62 billion by 2031, both as a result of revenues from the rebates and reduced list price growth overall.
How The New Provisions Affect Premium Growth
Under the current design of Part D, premiums have remained relatively stable and below the CBO’s initial projections even as list prices and cost sharing have grown. The payment reforms of the IRA—Medicare negotiation, the redesign of Part D, and inflation rebates—ensure that limiting cost sharing will increase affordability of high-price drugs without ballooning spending in the program over time. However, they will affect the value and availability of rebates that have historically been used to keep Part D premiums low. The degree to which savings to the program coincide with changes to the flow of rebates will depend on how quickly market participants adapt to the IRA’s multiple different reforms. To ensure that Part D premium growth remains stable in the interim, the act constrains the beneficiary share of premiums to grow by no more than 6 percent through 2030, with Medicare covering shortfalls if plan sponsors’ costs grow faster.
The IRA In The Bigger Picture Of Drug Pricing Reforms
In responding to high list prices and growing unaffordability of prescription drugs, the IRA takes aim at several problems: a failure of competitive pressure to act on list prices, inadequate negotiating leverage among plan sponsors for drugs with coverage guarantees or no therapeutic alternatives, and open-ended exposure of Medicare and its beneficiaries to the consequences of high list prices. The reforms contend with readily observable pricing trends that have had deleterious financial consequences for beneficiaries and grew particularly concentrated among a subset of branded prescription drugs.
This confluence of factors created momentum for reforms that will reshape how Medicare pays for aging and branded products, while leaving the market for new products unaltered. The CBO estimates that the impact of the law on new drug development will be relatively small: two fewer drugs entering the market in the coming 10 years, and 13 in the subsequent two decades. Overall, the agency projects that approximately 1,300 new drugs will be approved over the next 30 years. In other words, the volume of new drug approvals will likely continue unabated, especially as manufacturers begin developing new products to replace declining revenues from older ones affected by the IRA.
Meanwhile prices of new drugs have been rising, and the CBO expects higher launch prices following the implementation of the IRA’s policies. Manufacturers will continue to set list prices, eventually allowing them to incorporate anticipated concessions for inflation rebates and negotiation, particularly for drugs with no close therapeutic substitutes.
These trends promise to shape future spending challenges not only for Medicare but also for other payers, including privately purchased or employer-sponsored health insurance. However, reforms in the IRA were not extended to the private market because it was passed through budget reconciliation, a special legislative procedure that allows lawmakers to avoid a Senate filibuster but comes with rules that limit the scope of reforms. Although the act will likely have spillover effects that affect the entire market, such as downward pressure on list prices, concerns about affordability of prescription drug coverage among the privately insured and uninsured will likely continue to grow. As the IRA begins to reshape how Medicare pays for drugs, it may yet prove to be just the first step in response to continued political pressure for reform.
The author is an employee of ATI Advisory, which provides consulting services in the health sector and receives grant funding from foundations, including Arnold Ventures and West Health. She is also a former staffer to the Senate Committee on Finance and was previously the program director of the Drug Pricing Lab at Memorial Sloan Kettering Cancer Center, which received grant funding from Arnold Ventures.