The Paradox of Pricing pt. 1: Drugs by D.A. Wallach

A striking feature of the recent presidential primary debates has been the candidates’ conspicuous ignorance of the drivers of our healthcare system’s irrepressible costs and middling patient outcomes. All agree, correctly, that the U.S. is in deep trouble: of the 10 wealthiest nations, we spend almost twice the average on healthcare (18% of our GDP) and yet have the lowest life expectancy and quality ratings to show for it. Hard-working families are struggling to pay rapidly increasing insurance premiums, and high deductibles, co-pays, and coinsurance make matters worse.

How convenient it would be if we could blame all this on a single, obvious bad guy! Politicians love to shoot invectives at “evil” insurance and pharmaceutical companies. But among those of us who witness the system up close, the reality is far more complex. There are no tidy culprits here; rather, our system is like a mindless zombie sucking money out of our economy and redistributing it in the service of irrational, perverse incentives that no one truly endorses.

Are drug prices rising?

Take prescription drug prices, which all of the candidates seem to agree are unconscionably high. On the surface, the prices of drugs do appear to be rising rapidly, along with the co-pays that patients shoulder at the pharmacy. What most people don’t know is that drugs actually have two different prices: a list price and a net price. The list price is like an MSRP (manufacturer suggested retail price), and is typically what the pharmacy charges for a drug.

If you have insurance, and your deductible has been met for the year, then in theory your insurer will pay the pharmacy the full list price for the drug you’re buying. Behind the scenes, however, your insurer has negotiated a rebate with the drug company. So if, for example, you pick up a drug with a list price of $100, it’s possible that your insurer will pay the pharmacy the $100, but then collect a rebate of $70 directly from the drug company. To the insurer, the $30 difference between the list price and the rebate is the actual cost of the drug or its “net” price. And in reality, over the past several years, these net prices, the “real” prices of drugs, have stagnated.

You may be wondering how and why list prices can skyrocket while net prices remain roughly constant. The answer, as usual, derives from bizarre and unintended incentives of public policy. Within the ACA (“Obamacare”), there is a provision requiring insurance companies to spend 80% of their received premiums on claims, meaning that they cannot charge you $1000 a month and only spend $500 on your medical care. In other words, lawmakers intended to statutorily cap the margins of insurance companies to protect all of us from usurious rates. Ironically, this leads insurers to try to make money through other sources that don’t count against their capped 20% of premiums. Income from drug rebates is one such source! So…insurers want as much rebate income as they can generate. How can they increase rebates? Simple: push the drug companies to increase list prices!

At first glance, this dynamic seems odd but benign: net prices stay the same (so the “true” cost of drugs doesn’t go up) and insurers get to increase their margins without violating their underwriting caps. But unfortunately, the victims end up being patients needing expensive drugs via high deductible plans. The reason is that, if a patient has not met her deductible for the year, she will need to shoulder the full list price of the drug until that deductible is met. And if co-pays are a part of the patient’s plan, these co-pays will be a % of the list price, not of the net price. Thus, patients are forced to bear the brunt of higher list prices and drug companies appear rapacious (when they are not actually increasing margins).

Two more ironies surface in this tangle of mindless pricing incentives: 1) in the case of many large companies who pay for their own employee insurance costs, Human Resources departments have become rebate addicts! Remember I explained that the insurance companies like getting these rebates? Well, large employers who function as their own insurance companies for employees are no different. And faced with an option between negotiating lower drug prices (with no rebates) vs. higher drug prices with rebates, many employers choose the latter. Why? Because HR teams can take credit for rebates, and potentially augment their own internal budgets. Everyone here is just doing what makes rational sense for themselves, but in the aggregate, they are fueling a waste machine that grinds patients to the bone.

Irony #2 is that high deductible plans in Obamacare were meant to turn patients into “smart shoppers,” more judiciously comparing prices as they navigated the healthcare system. The idea was that, if you had to pay out of pocket for the first few thousand dollars of health expense each year, you’d think twice about getting a $2000 MRI when you could shop around and find the same thing for $500. Policymakers hoped this would help “consumerize” healthcare, unleashing market-like forces on health’s overpriced products and services. But early evidence suggests that this has not occurred. Rather, patients with high deductible plans (an increasing %) seem to be either abstaining from expensive care or just continuing to indiscriminately choose overpriced care. At the pharmacy, these high deductible plans have combusted with high list prices, leading patients to tragically ration their own life-saving drugs or in many cases not fill them at all. The reality has simply defied the theory.

Evolution vs Revolution

This seemingly straightforward issue — drug companies jacking up their prices — is a microcosm of our mind-bogglingly complex healthcare economy. The mindlessness of bad incentives is maddening since it defies our impulse to point the finger at any single bad actor. Well-intended policy (Obamacare), profit-seeking employers and insurers, beholden drug companies, and thrifty patients conspire in collective stupidity and harm.

This unwitting folly is ubiquitous in our system: rational decision-making by diverse actors produces macroscopic malady and malaise. Unfortunately, a wholesale revolution in public policy is unlikely to unwind these collective action problems. On the contrary, potentially viable solutions entail nuanced remodeling of the incentive landscape to align patients, the government, workers, investors, and employers around the virtuous goals of distributive justice and high quality care. As investors, we aim to promote these goals by backing innovative companies that put patients first and seek to rationalize costs in the broader system. Our hope is that politicians recognize and support the risk-taking and ambition of the visionary entrepreneurs we see every day dedicated to this work.

original source: http://www.dawallach.com/blog/2020/1/1/the-paradox-of-pricing-pt-1-drugs