The Human Cost of Federal Price Negotiations: The Medicare Prescription Drug Benefit and Pharmaceutical Innovation

The 2003 Medicare Prescription Drug, Improvement and Modernization Act created a prescription-drug benefit, Medicare Part D, effective January 1, 2006. For the first time, the federal government will pay for the prescription medicines used by American senior citizens. Part D differs from other federal and state drug programs, which mandate specific price discounts. Instead, private-sector Pharmacy Benefit Managers (PBMs) — including such well-established firms as Medco, Blue Cross, and Aetna — negotiate with drug companies to set prices and formularies (lists of covered drugs) for enrolled patients.

Because the prescription drug benefit is projected to cost hundreds of billions of dollars over the next decade, some policymakers have called for changing Medicare Part D, to require federal negotiation of prescription-drug prices. Such a change would aim to use the purchasing power of the federal government to force prices below those that would be negotiated by the private sector.

In addition to cost reductions, however, this policy change portends other ancillary effects. In particular, this paper estimates the impact that federal negotiation of prescription drug prices would have on pharmaceutical research-and-development (R & D) investment through 2025. It argues that federal policymakers would have incentives to favor price reductions at the expense of more-inclusive drug formularies. This greater willingness of federal officials to exclude drugs from formularies would lower drug prices below those that otherwise would be set by the market. This, in turn, would reduce incentives for the capital market to invest in the research and development of new medicines.

This report quantifies the results of such a decline in capital investment. It presents the results of a simulation analysis that projects pharmaceutical R & D investment, assuming, under three different sets of parameters, federal price negotiations for prescription drugs beginning in 2007.

• In the baseline case, developed from National Science Foundation (NSF) data on historical investment trends, the cumulative decline in research and development investment would yield a loss of 196 new medicines, or about ten per year.

• Using the same NSF data with a more conservative assumption about the growth rate of research and development investment, the loss would be 107 new medicines, or about six per year.

• Using historical investment data gathered by the Pharmaceutical Research and Manufacturers of America, the loss would be 220 new medicines, or twelve per year.

In the short run, federal price negotiations would allow some consumers to receive medicines at lower prices, or, alternatively, would yield savings for federal taxpayers. The longer-term human costs of government price-negotiation, however, are likely to be large and adverse. This paper estimates that investment in new drug research and development would decline by approximately $10 billion per year. It estimates as well the effect of reduced pharmaceutical R & D investment on American life expectancies, or expected “life-years”. Specifically, this work projects that federal price negotiations would yield a loss of 5 million expected life-years annually, an adverse effect that can be valued conservatively at about $500 billion per year, an amount far in excess of total annual U.S. spending on pharmaceuticals.

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