The Corporate Beneficiaries of the Medicare Drug Benefit

by Dean Baker

Millions of senior citizens and disabled people enrolled in Medicare Part D drug plans in 2006 discovered the “doughnut hole,” the unusual $2,850 gap in coverage that was placed into the plan to save the U.S. federal government money.

The doughnut hole is peculiar because it goes directly against the general design of insurance. Usually, insurance policies are designed to protect holders against large losses. Policies typically have deductibles and/or co-pays with the assumption that most people can afford modest costs. After a certain level of costs, the share borne by the insurer typically increases — this is the bad event against which the policy holder is insuring themselves.

The Medicare drug benefit effectively takes the opposite approach. There is an initial deductible, and the basic formula provides for a 25 percent co-payment, but the benefits continue only until the beneficiary incurs $2,250 in drug expenses for the year. At that point, the beneficiary is directly and fully liable for the next $2,850 in annual expenditures, with no assistance provided through the benefit. Only if expenses exceed $5,100 for the year will the insurance again provide benefits, at that point paying 95 percent of additional expenses. 

The size of this doughnut hole will grow in the future, since the basic benefit schedule is indexed to average per person drug spending, which is projected to grow at a rate of more than 8 percent annually. The expected size of the doughnut hole in 2007 is $3,078. By 2016, it is projected to grow to $6,100.

This peculiar design was adopted in order to limit the cost of the Medicare drug benefit. Starting in 2007, when most participants will be enrolled for the full year, the doughnut hole will transfer costs of about $20 billion to beneficiaries — these are costs beneficiaries will have to cover out of pocket, thanks to the doughnut hole.

There were other ways in which costs could have been contained. Most notably, the brand-name pharmaceutical industry successfully pressed Congress to prohibit Medicare from bargaining directly with the drug companies to lower prices. This passive acceptance of drug company monopoly prices may have added more than $40 billion to the annual cost of the program in its first years. Congress also stipulated that the program would be administered through private insurers rather than the existing Medicare program — a decision that the Congressional Budget Office (CBO, an independent Congressional research agency) estimates added nearly $5 billion a year to the program’s expenses, and that imposed billions more in indirect costs on beneficiaries.

Pharma’s Benefit

In adopting the Medicare drug benefit, Congress stipulated that Medicare could not directly negotiate price discounts with drug manufacturers, as is done by the Veterans Administration (VA) and the healthcare systems in most other wealthy countries. As a result, prescription drugs cost far more under the Medicare drug benefit plan than is necessary. In the case of many drugs, the prices paid by insurers participating in the plan are more than twice as high as the prices paid by the VA.

Since the industry is already making a profit at the price for which it sells drugs to the VA , the higher price paid by the private insurers participating in the Medicare drug benefit is pure profit for the drug industry.

Comparing the Veterans Administration price for drugs with those available in the Medicare drug program shows the huge price differences between what Medicare is paying and what it might pay, if it negotiated as well as the VA. Multiplying this differential by the number of prescriptions in the Medicare plan reveals the excess profits earned by the industry for each drug — in just one year of the program. (In the accompanying table, the calculation of excess profits is based on the difference between a weighted average of the prices available through insurers participating in the Medicare drug benefit and the price at which the drug can be obtained through the Veterans Administration. The calculation is based on the assumption that 70 percent of the prescriptions for the top 20 drugs among seniors were used by seniors in the Medicare drug plan.)

For several of the drugs, the excess profits are substantial. The excess profits earned on Protonix, a heartburn medication, are just under $1 billion. The combined excess profits earned on the two dosages for Zocor, a cholesterol-lowering drug, are more than $1.6 billion. The combined excess profits for the two dosages of Lipitor, another cholesterol-lowering drug, come to $1.2 billion.

The excess profits on this small group of drugs is fairly sizable relative to the doughnut hole gap in coverage under the prescription drug plan. The excess profit earned on Protonix alone is almost 5 percent of the size of the doughnut hole. The excess profits on Lipitor are close to 6 percent of the size of the doughnut hole. 

There are thousands of different types of drugs, dosages and delivery mechanisms, which in nearly all cases cost more than necessary under the Medicare drug plan, because Congress prohibited Medicare from directly negotiating drug prices with the pharmaceutical industry. If Medicare had been allowed to negotiate in the same way as the Veteran’s Administration, the savings would have been enough to eliminate the doughnut hole gap in coverage, even using conservative assumptions.

The Congressional Budget Office has found that drug prices in other industrialized countries are 35 to 55 percent lower than in the United States. Those countries also do a better job than the United States at controlling drug price inflation. These countries use various mechanisms to control price, but they ultimately reflect the countries’ bargaining power — drug companies are always free not to sell, if they don’t like the price. Medicare would be a larger buyer than any one country, so it is reasonable to assume it could at least match, and likely undercut, the prices available in other countries.

If Medicare as negotiator were to do only as well as the most-expensive industrialized country — reducing prices 35 percent and controlling inflation — it would, from 2006 to 2013, save $332 billion versus what CBO projects will be spent under the existing rules. If Medicare did as well as the least-expensive industrialized country — reducing prices 55 percent and controlling inflation — it would save $563 billion over the 2006-2013 period.

Instead of being allocated to eliminate the doughnut hole or for other public purposes, those monies are landing in pharmaceutical company coffers.

Aiding the HMO/Insurers

Big Pharma’s subsidy is not the only corporate welfare component of the Medicare drug benefit. The decision to offer the benefit through private insurers instead of the existing Medicare system imposes two sets of additional costs.

The Congressional Budget Office projected in July 2004 that additional administrative costs due to the marketing expenses and profits of the private insurers would be approximately 10.7 percent of overall costs in the first year for which the program was in operation, for a total of $4.6 billion. These additional administrative costs exclude the inherent costs in running a large program, such as dispensing fees paid to pharmacies and other costs of processing claims. The additional administrative costs are incurred only because of the decision to use multiple private insurers: “expenses that drug plans would incur for marketing, member acquisition and member retention,” according to CBO. The uncertainty around projecting costs into the future will also impose costs that a public insurer would not face. CBO “assumed that plans would incur costs as a result of having to bear financial risk — whether to offset the costs of purchasing private reinsurance policies or to build up their own reserves in case their costs exceeded expectations.”

CBO estimated that overall additional administrative cost would stay roughly the same over time, increasingly slightly to $4.9 billion by 2013.

From 2006 to 2013, according to CBO’s estimates, the additional administrative cost from using multiple private insurers, instead of a single government payer, will total $38 billion.

The second set of expenses from having private insurers manage the plan involve the time spent by beneficiaries and healthcare providers in navigating the additional complexity of a system with multiple insurers. Quantifying this cost is difficult, but it is possible to calculate the general order of magnitude. A survey by the Medicare Payment Advisory Commission found that more than half of the people who had signed up for a Medicare Part D plan (the survey was conducted in February and March 2006) had spent more than eight hours examining their options.

Assigning the economy-wide average hourly compensation for workers as the value of this time implies that the cost of this selection averaged $240 for the beneficiaries who went through this process. More than 20 million people are enrolled in Medicare Part D. More than 11 million of them did not previously have prescription drug coverage from Medicare or Medicaid (though many had prescription drug coverage through other, private providers).

It is understandable that many seniors would have viewed this expenditure of time as a substantial and unnecessary burden. In principle, this will be a one-time expenditure of time, since most seniors will probably opt to remain with the plan they have chosen. However, it is possible that changes in their prescription drug usage or changes in the plan coverage may make their current plans less desirable. It may also be the case that some insurers may opt to leave the market. In such circumstances, beneficiaries will be forced to go through the process of selecting a plan again. 

Time costs are also incurred by doctors and other healthcare providers in helping beneficiaries navigate the system. No reliable data exists yet to measure how much time the benefit is actually requiring from providers, but there is some anecdotal evidence suggesting that the cost is substantial.

Of course, even the simplest benefit would require some amount of time from doctors, as they would still be required to consider cost as a factor in choosing medicines. But this time would be far less if there were just a single set of prices and rules. Also, if Medicare had bargained drug prices down closer to their production costs, price differences would usually not be large. This would allow doctors to make their prescription decisions based primarily on their assessment of the best drug for their patients.

In addition to the demands on doctors’ time, the complexity of the plan is also placing a large burden on pharmacists. They have had to learn the rules for the various plans that are part of the Medicare program. Pharmacists have also had to deal with slip-ups with the system, which have often left people without proper coverage. In these cases, pharmacists have frequently opted to still provide drugs to customers in the hope of getting payment later, rather than sending Medicare beneficiaries home without necessary medication. Such situations have involved large amounts of time, and exposed pharmacies to financial risk.

A Peculiar Program

The peculiar features of the Medicare Modernization Act have imposed large costs on seniors, people with disabilities, the government and healthcare providers. The rule that prohibits Medicare from negotiating price discounts directly with the pharmaceutical industry, has added hundreds of billions of dollars to the cost of the program over its first decade. In addition, the decision to only provide the benefit through private insurers substantially increased both the cost and complexity of the program.

These costs are not unavoidable expenses associated with a major program. They are the result of counterintuitive rules and designed-in complexity, all crafted to serve the interests of the program’s big financial beneficiaries: Big Pharma, and the insurance plans.

Dean Baker is co-director of the Center for Economic and Policy Research