Frank, Richard G., and Richard J. Zeckhauser. "Excess Prices for Drugs in Medicare: Diagnosis and Prescription." HKS Faculty Research Working Paper Series RWP18-005, January 2018.


Excess prices for drugs in the U.S. is a persistently vexing policy problem. While there is agreement among most policy analysts that supra competitive prices are necessary to promote innovation; significant disagreements arise over how much pricing discretion prescription drug manufacturers should be permitted, and what portion of the sum of producer plus consumer surplus in the prescription drug market should be claimed by manufacturers relative to consumers and other payers. This analysis first diagnoses the causes of the high costs in Medicare Part D. It then makes use of that diagnosis to provide a prescription for policy measures that have the potential to simultaneously reduce these costs without significantly sacrificing incentives to bring valuable new drugs to market. This paper focuses on an extremely costly component of the Medicare Part D program, the region of coverage that kicks in once a consumer has spent $4,950 on drugs in a calendar year (roughly $8,100 in total drug spending). At that point there are high levels of insurance for the consumer and reinsurance for the prescription drug plan. Consumers pay 5% of costs; plans pay 15% and the government 80%. That design generates serious inefficiencies. The significant subsidies to plans in the reinsurance region combined with the launch of unique high cost prescription drugs could be expected to lead to and has led to substantial departures from cost-effective outcomes in treatments delivered. As would be expected, spending has been growing rapidly in this so called “reinsurance region”. What is less well known is that a small number of very high-cost drugs account for almost all of this growth. Following this diagnosis, we present two, possibly complementary, prescriptions for reducing these inefficiencies. The first follows on the MedPac recommendation that the government reduce its share of risk bearing for the Part D reinsurance benefit. The second focuses on curbing price inefficiencies for those very high-cost drugs. That prescription has two components: eliminating monopolistic overpricing, and promoting the quality of drugs brought to market. It is grounded in the economics of two part tariffs, research on innovation prizes, performance-based contracts, and draws on the mechanism design literature. Such pricing could save substantially on costs without curtailing the most important R&D efforts for pharmaceuticals. Market conditions and political forces appear ripe for significant new approaches to pricing high cost drugs in Medicare Part D. We believe that the prescription discussion here, which draws on this paper’s diagnosis, identifies some promising approaches to a vexing problem.