That $56,000 Drug? Blame Medicare.

For an increasingly important set of drugs, Medicare has been driving up prices. It knows how to do better.

By Amy Finkelstein. Excerpts:

"When people buy prescription drugs from pharmacies, Medicare heavily subsidizes private insurance coverage and lets the insurers negotiate prices with manufacturers as they see fit. This approach is not perfect, but the economists Mark Duggan and Fiona Scott Morton found that when Medicare introduced it in 2006 when it expanded drug coverage, the result was lower drug prices.

That’s a stunning finding, because basic economics would suggest the opposite effect. When drugs are covered by insurance, patients’ prescription choices typically become less influenced by drug prices, since insurers are picking up most of the tab. Manufacturers are therefore expected to respond by raising prices.

But when Medicare expanded coverage, prices dropped because of a stronger, countervailing effect. Private insurers, which had greater leverage and bargaining savvy than individual consumers, were better able to negotiate lower prices with the drug manufacturers.

For physician-administered drugs, however, Medicare’s policy has raised prices. Medicare has covered such drugs since its inception in 1965, but in the last few decades they have become increasingly important, particularly for treating cancer. For these drugs, Medicare tries to piggyback on the market’s price-setting by matching what other customers pay, plus a little extra for the physician.

This sounds reasonable enough, but the problem is that Medicare’s patients often account for a major share of the drug’s market. When a large purchaser commits to pay what other customers pay, sellers respond by raising drug prices, the evidence shows.

Consider that more than 95 percent of the six million Americans afflicted by Alzheimer’s are covered by Medicare. What price might you charge if the major purchaser for your drug has committed to pay whatever “other customers” pay? Biogen, the drug’s manufacturer, came up with a price of $56,000 per year."

Medicare has yet to announce which Alzheimer’s patients will be covered for the new drug, which the F.D.A. approved against the recommendation of clinical experts. The annual cost to the federal government is, therefore, not yet known, but it could be extremely high.

More important, this drug and its pricing are an extreme case of a pervasive problem. Estimates from a few years ago suggest that Medicare patients are, on average, about one-third of the market for the most expensive of the physician-administered drugs. If Medicare abandoned its current policy, prices on these top-selling drugs could come down by as much as one-third. That estimate is based on the drug pricing effects of a similar policy under Medicaid, the government’s health insurance program for low-income people.

There are continuing, but so far unsuccessful, efforts in Congress to change how Medicare pays for these drugs. It is important to recognize, however, that any policy that substantially lowered drug prices would have the unavoidable effect of decreasing patient access to some drugs.

One set of proposals would authorize private insurers or other intermediaries to negotiate prices with manufacturers. Physician-administered drugs might, for example, be folded into the current Medicare policy for pharmacy drugs. For this type of approach to be effective, the negotiators must be able to walk away from a drug if the price is too high; otherwise, they lose leverage with manufacturers. Some drugs, therefore, might no longer be covered at all, or have much more limited coverage.

Under another approach, the U.S. government would impose lower drug prices through direct regulation, as many other countries do. In this case, access to existing drugs would be retained, but, as a large body of evidence shows, pharmaceutical companies would spend less on research and development, and develop fewer new drugs.

Economists tend to favor letting the private sector set prices, but this requires a well-functioning market. In trying to base its payments on what other customers pay, Medicare has distorted the market for physician-administered drugs beyond reason."