CONGRESS OF THE UNITED STATES

CONGRESSIONAL BUDGET OFFICE

A

CBO

STUDY

OCTOBER 2002

Issues in

Designing a

Prescription

Drug Benefi t

for Medicare

© Royalty-free/Corbis

CBO

A

S T U D Y

Issues in Designing

a Prescription Drug Benefit

for Medicare

2FWREHU 

The Congress of the United States ■ Congressional Budget Office 
Note

Numbers in the text and tables of this study may not add up to totals because of rounding.
Preface

0edicare offers broad insurance protection for many health needs of the nation’s

elderly and disabled residents, but it provides no coverage for the costs of most outpatient

prescription drugs. As spending for those drugs has soared in recent years, adding a prescription drug benefit to Medicare has become a top health issue for lawmakers. However,

designing such a benefit as a freestanding addition to the existing Medicare program has

proved difficult—in part because the design choices involve trade-offs among a number of

competing policy goals. 

This Congressional Budget Office study discusses CBO’s approach to estimating the costs of

various designs for a Medicare prescription drug benefit. The study describes the broad

choices available to policymakers, some problems raised by particular design choices, and the

implications of those choices for the cost of four specific proposals, which together cover a

wide spectrum of approaches for delivering a Medicare drug benefit. In keeping with CBO’s

mandate to provide objective, impartial analysis, this study makes no recommendations.

The study was written by current and former staff members of CBO’s Health and Human

Resources Division and Budget Analysis Division, including Joseph Antos, James Baumgardner, Jennifer Bowman, Kathleen Buto, Julia Christensen, Sandra Christensen, Jeanne

De Sa, Eric Rollins, Rachel Schmidt, Sarah Thomas, and Judith Wagner. Kate Bloniarz,

Samuel Kina, and Daniel Wilmoth provided valuable assistance. Steven Lieberman and

Deborah Lucas of CBO provided helpful comments on drafts of the report, as did Bryan

Dowd of the University of Minnesota, Richard Frank of Harvard University, and Robert

Reischauer of the Urban Institute. (The assistance of external reviewers implies no responsibility for the final product, which rests solely with the authors and CBO.)

Christian Spoor integrated the contributions of the authors into a single edited text. Christine

Bogusz proofread the study. Ronald Moore produced drafts of the manuscript. Kathryn

Winstead prepared the study for publication, and Annette Kalicki prepared the electronic

versions for CBO’s Web site.

Dan L. Crippen

Director

October 2002

This study and other CBO publications

are available at CBO’s Web site:

www.cbo.gov









CONTENTS

Summary ix

Introduction 1

Medicare Beneficiaries’ Drug Spending and Coverage 3

Beneficiaries’ Spending on Prescription Drugs 3

Distribution of Beneficiaries’ Drug Spending 4

Beneficiaries’ Existing Drug Coverage 4

Design Choices for a Medicare Drug Benefit 9

The Structure of the Coverage 10

Eligibility for Enrollment 11

The Level and Structure of Federal Subsidies 11

Administrative Approach 14

Problems in Designing a Medicare Drug Benefit 17

Selection Issues 17

Cost Containment 22

Administrative Feasibility 29

Effects on Other Parts of Medicare 31

Cost Estimates for Specific Proposals 35

CBO’s Key Assumptions 36

Details of Four Recent Proposals 37

Cost Estimates for the Four Proposals 43

Appendix A

Formulary-Based Strategies for Cost Control

Used in the Private Sector 45

Appendix B

Evidence About How Drug Coverage Affects

the Use of Other Health Care Services 49
vi ISSUES IN DESIGNING A PRESCRIPTION DRUG BENEFIT FOR MEDICARE

Tables

S-1. Provisions of Four Prescription Drug Proposals

for Medicare xvi

S-2. Federal Costs of Four Prescription Drug Proposals,

2005-2012 xviii

1. Prescription Drug Spending and Medicare Benefits

per Beneficiary, 2003-2012 4

2. Prescription Drug Spending by or for Medicare

Beneficiaries, 2005 4

3. Medicare Beneficiaries’ Prescription Drug Coverage, 1999 6

4. Medicare Beneficiaries’ Prescription Drug Coverage and

Spending, by Income Level, 1999 7

5. Provisions of Four Prescription Drug Proposals

for Medicare 38

6. CBO’s Assumptions for Four Prescription Drug Proposals 40

7. Federal Costs of Four Prescription Drug Proposals,

2005-2012 43

Figures

1. Spending for Social Security, Medicare, and Medicaid,

2000-2030 2

2. Sources of Payment for Medicare Beneficiaries’

Prescription Drugs, 1999 5

3. Hypothetical Structure of a Medicare Prescription

Drug Benefit 10

4. The Role of PBMs in the Flow of Money and

Prescription Drugs 15
CONTENTS vii

Boxes

1. The Feasibility of Risk Adjusting the Drug Benefit

in Competitive Plans 23

2. How a Medicare Drug Benefit Would Interact with

Supplemental Drug Coverage 25

3. State Insurance Laws That Affect Prescription Drug Plans 32

Summary

2ne of lawmakers’ highest health-related priorities

is adding a prescription drug benefit to Medicare. Although that program gives older Americans broad insurance coverage for many health needs, it provides only

limited coverage of drugs not dispensed during a hospital

stay. That gap in coverage has become increasingly

significant as prescription drugs have assumed greater

importance in the treatment of disease and as spending

for outpatient prescription drugs has soared.

Designing a Medicare drug benefit is a complex task,

however. The competing goals for such a benefit mean

that policymakers must make trade-offs (such as between

broad coverage or widespread enrollment and cost). They

must consider many different design elements and how

those elements might interact. And they must try to avoid

various problems that arise in creating such a benefit.

Ultimately, the choices that designers make will affect not

only the cost of the benefit but a host of other factors,

such as demand for and prices of prescription drugs,

spending by other federal and state programs, and how

various parts of the market for health insurance operate.

The Congressional Budget Office (CBO) has had to

wrestle with those issues in recent years to produce cost

estimates of the various Medicare drug proposals debated

in the Congress. This study summarizes the main design

choices facing policymakers and explores the implications

of those choices for cost and coverage. To illustrate the

effect of those choices on cost, it also discusses CBO’s

cost estimates for four proposals that represent a broad

array of designs for a Medicare drug benefit.

For the sake of simplicity, this study focuses on a standalone drug benefit—one that would be a freestanding

addition to Medicare rather than part of a broad effort to

restructure the program. Broad reform proposals raise

important policy issues but ones that are beyond the

scope of this analysis.

Higher Drug Costs and Declining

Coverage Are Spurring Calls

for a Medicare Drug Benefit

Spending for prescription drugs is the fastest growing

segment of U.S. health care costs. And Medicare beneficiaries (people who are 65 or older or disabled) account

for a disproportionate share of that spending: about 40

percent, although they make up less than 15 percent of

the U.S. population. CBO expects Medicare beneficiaries’

drug costs to rise rapidly over the next decade (even without adding a drug benefit to Medicare)—at a per-beneficiary rate of 10.1 percent a year, on average. That rate is

much faster than the projected growth of spending for

current Medicare benefits, and more than twice as fast as

the expected per capita growth of the U.S. economy. 

This year, Medicare beneficiaries will use a total of almost

$87 billion in outpatient prescription drugs. That figure

is projected to rise to more than $128 billion by 2005,

the earliest year that Medicare could probably begin implementing a drug benefit that was enacted in 2002.

Although most Medicare beneficiaries use some prescription drugs, that spending is concentrated among a rela-
x ISSUES IN DESIGNING A PRESCRIPTION DRUG BENEFIT FOR MEDICARE

tively small part of the Medicare population: people with

chronic conditions requiring long-term drug therapy.

Only 17 percent of Medicare beneficiaries will spend

more than $5,000 on prescription drugs in 2005, CBO

estimates, but their combined spending will make up

nearly 54 percent of total drug expenditures by Medicare

beneficiaries that year.

Roughly one-quarter of Medicare beneficiaries have no

prescription drug coverage (as of 1999, the most recent

year for which data are available). Thus, they must pay all

of their drug costs out of pocket. The other three-quarters

obtain drug coverage as part of a plan that supplements

Medicare’s benefits. But those supplemental plans differ

greatly in the extent of coverage they provide. And recent

trends suggest that the availability and comprehensiveness

of supplemental drug coverage may be declining. Many

employment-based health plans for retirees have been

scaling back drug benefits in the face of rising costs. The

same is true of managed care plans that participate in the

Medicare+Choice program, some of which offer drug

coverage as an additional benefit.

Medicare beneficiaries who have drug coverage had an

average of about 32 prescriptions filled in 1999. The onequarter of Medicare beneficiaries without drug coverage

used fewer prescription drugs that year—but still had an

average of 25 prescriptions filled. Medicare beneficiaries

who lack drug coverage tend to be people in the low to

middle part of the income distribution. People with

higher income are more likely to have employment-based

plans or individually purchased medigap policies (which

charge high premiums for drug coverage). People with the

lowest income qualify for drug benefits from Medicaid or

from state-sponsored pharmaceutical assistance programs.

Proposals that would target Medicare drug coverage toward low- to middle-income beneficiaries who are not

eligible for Medicaid would concentrate new federal

spending on those least likely to have drug coverage now.

Broad-based proposals, by contrast, would tend to replace

coverage that three-fourths of beneficiaries now get from

private and nonfederal sources with Medicare-funded

coverage. CBO expects that broad-based proposals for a

Medicare drug benefit would redistribute some drug financing from employers and states to Medicare.

Design Choices for a Medicare Drug

Benefit Must Balance Competing

Objectives

Policymakers cite various goals for a Medicare prescription drug benefit, some of which may be incompatible.

Those goals include making sure that all Medicare beneficiaries have access to drug coverage, offering coverage that

is relatively comprehensive and that reimburses some

share of costs for most enrollees, providing insurance protection for elderly people who have the highest drug

spending, ensuring that enrollees’ premiums are affordable, and limiting the cost to the federal government.

A Medicare drug benefit could require substantial federal

spending, especially if the government subsidized a large

share of the costs for many enrollees. Medicare beneficiaries are expected to spend an average of nearly $2,500

apiece on outpatient prescription drugs next year, and

access to better drug coverage would undoubtedly stimulate further spending. However, policymakers could exacerbate or alleviate the federal cost burden through their

decisions about the design of the benefit.

How Comprehensive Will the Benefit Be?

The most important factor determining the cost of a

Medicare drug benefit is the scope and structure of its

coverage. Choices about coverage include: 

 The deductible amount—whether coverage begins

with an enrollee’s first dollar of drug spending in a

given year or after the deductible amount is reached;

 Cost-sharing rates—what part of the cost of a prescription is the responsibility of the enrollee;

 The benefit cap—the level of spending beyond which

the enrollee must pay the full cost of each prescription;

and
SUMMARY xi

 The catastrophic stop-loss amount—the level of

spending beyond which the enrollee pays little or nothing for prescriptions.

The possible variations on those choices are endless.

Some combinations could produce Medicare drug benefits unlike anything available in the private sector today.

(For example, many of the recent Medicare proposals envision a hole in coverage: a spending level between the

benefit cap and the stop-loss amount at which enrollees

would have no drug coverage. Employment-based drug

plans almost never include such holes.)

The benefit structure would affect the cost of the Medicare drug program not only directly but also indirectly,

through the out-of-pocket expenses it would require of

enrollees. For instance, benefits with low cost-sharing

rates would encourage those enrollees who were newly

shielded from paying the full cost of a prescription to use

more—and more expensive—drugs.

Who Will Be Eligible to Enroll? 

Choices about eligibility include whether the prescription

drug benefit would be available to all Medicare beneficiaries or only to some (such as those with low income, few

assets, or no current drug coverage). Another key decision

is whether to make enrollment in the drug benefit voluntary and, if so, with what restrictions. If the benefit was

voluntary and did not limit when and how often eligible

people could enroll, Medicare beneficiaries would tend to

sign up (and pay premiums) only when they expected to

incur high drug costs; they would opt out again when

they foresaw little need for prescription drugs. As a result,

the cost of the program per participant would be higher

than if people had to enroll and pay premiums for a

longer period of time.

How Much Will the Government Subsidize?

To what extent will the government pay enrollees’ costs

for premiums or prescriptions? And will those subsidies

vary with enrollees’ income? Those design choices affect

not only federal spending but also spending by state and

local governments, which help pay the drug costs of some

low-income elderly people through Medicaid and other

programs. In addition, the level of subsidy offered to

Medicare beneficiaries would have an important effect on

people’s willingness to enroll in the drug program.

How Will the Benefit Be Administered? 

Almost all of the recent proposals for a Medicare drug

benefit envision using organizations such as pharmacy

benefit managers (PBMs) to administer the benefit—an

approach that is common in the private sector. Critical

choices, however, are the number of such organizations

that would serve a region, the restrictions they would be

subject to, the basis on which they could compete for

enrollees, and whether they would assume any insurance

risk (that is, be liable for any costs that were not fully covered by enrollees’ premiums or federal reimbursements).

In examining prescription drug proposals, CBO has concluded that certain administrative features offer the greatest opportunity to control federal costs and total spending

on outpatient prescription drugs. Those features are allowing benefit managers to employ the full array of costmanagement tools now available to private-sector drug

plans, forcing benefit managers to compete among themselves for enrollees’ business, and making managers assume financial risk for delivering benefits.

Benefit Designs Must Address

Multiple Problems

In making the design choices described above, policymakers need to consider several problems inherent in

creating a Medicare drug benefit. Those problems include

the possibility that the coverage will mainly attract people

with the highest drug costs, the need to limit costs to the

government and to enrollees, the ability and willingness

of private entities (such as health insurers and PBMs) to

administer the drug benefit, and the possible impact of

the benefit on other parts of the Medicare program.

Adverse Selection

A stand-alone prescription drug benefit could be especially prone to the insurance-market phenomenon known
xii ISSUES IN DESIGNING A PRESCRIPTION DRUG BENEFIT FOR MEDICARE

as adverse selection, in which people who expect to have

higher-than-average costs disproportionately enroll in an

insurance plan. Adverse selection can occur when plans

(or potential enrollees) make decisions based on the desire

to avoid attracting (or being grouped with) enrollees who

are likely to have expensive claims. For example, health

insurers can design their coverage or market their plans in

ways that will be especially attractive to relatively healthy

people. And potential enrollees who would rather not be

in an insurance pool with people who are likely to have

high costs—because that would imply higher premiums

than would otherwise be the case—may opt out of insurance altogether.

Adverse selection is a problem because it undermines the

purpose of insurance, which is to spread financial risks

among a wide pool of people. Adverse selection raises the

cost of insurance for people who do enroll. And it makes

people who are discouraged from enrolling worse off by

not receiving the benefits of insurance. (Even people who

expect to have low medical costs could benefit from insuring against the possibility that they develop a serious

illness.) The outcome of adverse selection can be a pattern of high premiums and low enrollment, resulting in

much less coverage than would exist otherwise.

Two kinds of adverse selection could affect the operation

of a Medicare drug benefit: adverse selection into the

drug program as a whole; and, if multiple plans are allowed to administer the drug benefit in the same region

and bear financial risk for the cost of the benefit, adverse

selection among those plans.

Adverse Selection into the Drug Program. If relatively

healthy Medicare beneficiaries (such as those with no

chronic conditions) tended to opt out of Medicare drug

coverage, costs and premiums would be higher for people

who did enroll than they would be if the benefit covered

a representative mix of Medicare beneficiaries. Paradoxically, although adverse selection into the drug program

would raise costs per enrollee, it would most likely reduce

the total cost of the drug benefit, because the number of

participants would be so much smaller. Such a situation

could become unstable, however, with premiums continuing to grow and enrollment continuing to drop.

The main way to prevent adverse selection into the drug

program would be to encourage as many people as possible to enroll. The government could do that through a

number of approaches:

 Requiring One-Time Enrollment. A “choose it or lose

it” policy would boost enrollment because even healthy

Medicare beneficiaries might be worried enough about

developing an expensive medical condition someday

that they would enroll in the drug benefit if they had

only one chance to do so.

 Subsidizing the Program to a Large Extent. Broad federal subsidies would mean that even fairly healthy

people would be likely to get more in benefits than

they paid in premiums.

 Risk-Rating Premiums. Adjusting the premiums that

enrollees would pay according to their risk of high

drug spending would encourage healthier people to

enroll because their costs would be lower.

 Making the Drug Benefit a Mandatory Part of Medicare’s Part B. If drug coverage was incorporated into

Medicare’s Supplementary Medical Insurance benefits,

even people who expected to have low drug costs

would be inclined to enroll in order to insure against

the general medical expenses they might face. 

Adverse Selection Among Drug Plans. When a prescription drug program allows competing plans to operate and

requires them to assume financial risk for the benefits

they pay out, difficulties related to interplan adverse selection can result. That type of adverse selection occurs

when certain plans attract beneficiaries with high expected costs because their services or coverage are more

generous than are those of other plans. Drug plans would

probably react to the possibility of adverse selection by

trying to avoid enrolling people who are apt to have high

drug costs. For example, they might advertise their plans

at golf clubs but not at nursing homes. Or they might cap

benefits below the spending levels likely to be reached by

seniors with chronic health conditions, or they might

require substantial cost sharing.
SUMMARY xiii

The government could employ various policy tools to

minimize interplan adverse selection: it could require

plans to offer standardized benefits or could create standardized marketing materials for all Medicare drug plans,

or it could compensate plans for their differential costs

through reinsurance or risk adjustment. In addition, as

noted above, the government could allow drug plans to

charge risk-rated premiums.

Strategies that would reduce adverse selection, however,

could create other problems. Perhaps the most significant

is that if plans were shielded from the full burden of high

spending, they would have less incentive to control costs.

Thus, reducing the risks associated with interplan adverse

selection must be weighed against plans’ incentive to control costs.

Cost Containment

Medicare spending is expected to soar over the next three

decades as the large baby-boom generation becomes eligible for the program. Adding subsidized drug coverage to

Medicare would significantly increase the federal government’s financial commitment, particularly since Medicare

beneficiaries’ drug spending is projected to grow at

double-digit rates each year even without a drug benefit.

Thus, controlling costs is a key problem in designing such

a benefit.

The extent of the cost containment challenge depends on

the level of coverage provided. A more extensive benefit

would shift more of the burden of paying for drugs from

consumers to drug plans. In addition, by reducing out-ofpocket costs to enrollees, a Medicare drug benefit would

stimulate demand for prescription drugs. The more generous the coverage (the lower the deductible, the required

cost sharing, and the catastrophic stop-loss amount), the

greater would be the stimulus to demand—and the

greater the burden on cost management to limit that

growth in demand.

Active cost management by the entities administering the

Medicare drug benefit could encourage the use of fewer

or less-expensive drugs. The degree to which PBMs could

effectively control Medicare drug costs would depend on

their being allowed and encouraged to aggressively use the

various tools at their disposal. Those tools include formularies (lists of drugs that a health plan will cover) and

related approaches that steer demand to preferred drugs,

networks of pharmacies, disease-management programs,

and efforts to educate patients and physicians. All of those

tools, to one degree or another, work by influencing physicians’ or consumers’ choices about what drug to prescribe or where to fill a prescription.

In addition, requiring benefit managers to assume some

insurance risk for the benefits they pay out and allowing

multiple entities to compete for enrollees on the basis of

premiums and reimbursements would give managers a

greater incentive to hold down spending. However, the

savings from those features would be partly offset by two

kinds of additional costs:

 The Insurance-Risk Premium. Riskier enterprises require higher dollar returns to operate than less risky

ones do, because unless investors are compensated for

bearing the extra risk, investment in those enterprises

will dry up. A design that made PBMs or other benefit

administrators bear insurance risk would impose a

higher cost on those entities than would a design that

left insurance risk in the hands of the government.

That added cost is referred to as the insurance-risk

premium.

 Plans’ Marketing Costs. Competition would introduce

additional expenses associated with marketing to and

enrolling Medicare beneficiaries, which would not

arise if a single plan administered the drug benefit in

each region. Competing plans would have to provide

specific information about their plans to beneficiaries.

If plans were also responsible for enrolling people and

collecting their premiums, the cost of carrying out

those administrative functions would be higher than

under a single-plan system.

Ways exist to keep the insurance-risk premium and marketing costs in check without losing most of the savings

from a competitive system with active benefit management. One approach would be to limit insurance risk by

providing reinsurance to plans for very high cost enrollees. Under one type of reinsurance mechanism, a drug
xiv ISSUES IN DESIGNING A PRESCRIPTION DRUG BENEFIT FOR MEDICARE

plan would receive government funds on the basis of the

claims incurred by each of its enrollees. If an enrollee’s

claims in a year reached a specific level, the government

would pay the plan a certain fraction of the enrollee’s

additional claims costs. That fraction would increase as

the enrollee’s claims grew. With such a mechanism, plans

would still have an incentive to actively manage the drug

benefit, but they would be protected from uncontrollably

high-cost enrollees.

The extra marketing and administrative costs associated

with competition could also be reduced (though not eliminated) by standardizing the information given to Medicare beneficiaries, by having the government perform the

functions of enrolling beneficiaries and collecting premiums, and by facilitating efficient marketing to prospective

enrollees.

Even the most effective benefit management, however,

would not keep the prices of some drugs from rising under a Medicare drug benefit. By raising the limit on consumers’ willingness or ability to pay for covered drugs, a

generous drug benefit would make newly insured patients

more tolerant of high prices. With such a benefit, if a

manufacturer developed a unique drug whose target population consisted mainly of Medicare beneficiaries, it

could raise the drug’s price (or, if the drug was new, enter

the market with a high launch price). Preventing very

high prices for such drugs would be difficult apart from

imposing direct price controls or threatening to deny or

delay coverage of the drug—actions that could increase

uncertainty about the market for new drugs and thus discourage investment in pharmaceutical research and development.

Fortunately, most drugs are not unique but instead face

competition from close substitutes. For such drugs, the

most likely effect of a Medicare drug benefit would be

only moderate price increases, and then only for drugs

with patent protection or exclusive marketing rights.

Nevertheless, the possibility that manufacturers of patentprotected drugs could raise prices underscores the importance of giving benefit managers both the incentive and

the authority to use cost-management tools.

Administrative Feasibility

Some proposals would require the private organizations

charged with administering the Medicare drug benefit not

only to play the roles that PBMs do in the private sector

but also to compete for enrollees, bear insurance risk, and

cope with federal (and possibly state) regulation. An

important area of uncertainty is whether private entities

would be willing or able to participate in the Medicare

drug program under those conditions. If they were not,

the program would take longer and cost more to implement nationwide.

Private organizations could face at least three barriers to

participation. First, in order to compete as risk-bearing

entities, most PBMs would probably have to form partnerships with insurance companies and seek state licenses.

Alternatively, PBMs could offer their traditional benefitmanagement services to insurance companies that would

provide the Medicare drug benefit. In either case, new

functional roles and relationships would need to be developed before private entities could bid to offer Medicare

drug plans. Second, plans might be reluctant to enter the

market early because of uncertainty about how competition among plans would work itself out. Especially in the

early years of the program, plans might be unable to

gauge their risk of interplan adverse selection or know

how effective their strategies to cope with such risk would

be. And third, plans would face regulatory hurdles unless

the states’ role in licensing and regulating participating

drug plans was clarified at the outset.

It is possible that only one plan or even no plans would

participate in the drug program in some areas. Without

multiple plans in a region, the full benefits of competition

would not be realized. If that happened, the government

might have to provide its own public plan as a fallback in

those areas (or offer extra financial incentives for private

plans to operate there) to ensure a competitive program

nationwide. Fallback plans would be very vulnerable to
SUMMARY xv

interplan adverse selection in any region where there was

also a risk-bearing plan. If the fallback plan was less aggressive than other plans in managing costs, the government could end up paying more, on average, in areas

requiring such direct intervention.

Impact on Other Parts of Medicare

Adding a stand-alone prescription drug benefit to Medicare would have ripple effects on the rest of the program.

For some seniors, greater access to outpatient prescription

drugs would improve their health, reducing their use of

hospitals and other services that Medicare now covers.

For other seniors, however, use of health care could increase. For example, using a greater number of drugs

raises the probability of adverse events—such as harmful

drug interactions or side effects—which could lead to

new or longer visits to hospitals, emergency rooms, and

other health care providers. Little good evidence exists

from which to determine the net effect of drug coverage

on other Medicare services; but overall, costs for other

Medicare services would probably not change significantly.

One part of Medicare that would most likely be affected

by the availability of a drug benefit is the Medicare+

Choice (M+C) program. Those effects would go in conflicting directions, however. On the one hand, the managed care plans that take part in the M+C program have

historically attracted beneficiaries by offering benefits beyond the basic Medicare package—the most desirable of

which is prescription drug coverage. If drug coverage was

available to beneficiaries of regular fee-for-service Medicare, M+C plans would lose one of their principal competitive advantages.

On the other hand, under a Medicare drug benefit, M+C

plans that offered drug coverage would be paid for the

value of that coverage rather than having to finance it

from their savings on administration or benefits. The

rising cost of prescription drugs and the lack of Medicare

payment for drug coverage (combined with 1997 changes

in payment rates) are reasons that M+C plans have cited

for dropping out of Medicare in recent years. Higher

payments, to cover the cost of a prescription drug benefit,

could help stabilize those plans’ participation.

Cost Estimates for Medicare Drug

Proposals Reflect the Choices Made

by Policymakers

In recent years, policymakers have offered a host of proposals for a Medicare prescription drug benefit. The types

of design choices described above have a significant effect

on those proposals’ costs. Four Medicare drug proposals

introduced during the 106th Congress (1999 to 2000) are

particularly good examples of the broad spectrum of benefit designs being considered and the various ways in

which a Medicare drug benefit could be administered.

Each year, when CBO updates its 10-year projections of

drug spending by or for Medicare beneficiaries, it also updates its estimates for those proposals as a way to evaluate

its estimating methods and key assumptions. Those proposals are the benefit described in the Clinton Administration’s June 2000 Mid-Session Review; the Robb amendment (introduced by Senator Charles Robb as amendment 3598 to H.R. 4577); H.R. 4680 (introduced by

Representative William Thomas), which passed the

House of Representatives in October 2000; and BreauxFrist II (S. 2807, introduced by Senator John Breaux).

The original versions of those four proposals would have

introduced a Medicare drug benefit in 2002 or 2003. In

updating its estimates, CBO used the same dollar

amounts included in the original proposals but assumed

that the new Medicare drug program would begin in

2005. For example, if a proposal called for a $250 deductible and a stop-loss amount of $5,000 in out-ofpocket spending, CBO used those dollar values for 2005.

(After that, it indexed them for projected changes in per

capita drug spending through 2012, the end of the current 10-year budget window.) Keeping the same nominal

values for the benefit’s initial deductible and stop-loss

amount while drug spending is growing tends to make

the proposals more generous than when they were intro-
xvi ISSUES IN DESIGNING A PRESCRIPTION DRUG BENEFIT FOR MEDICARE

duced. However, policymakers have been reluctant to

propose a new Medicare drug benefit with higher deductibles and catastrophic stop-loss limits.

The Design of the Four Proposals

All four proposals would offer drug coverage on a voluntary basis as a new Part D of Medicare, but they would

give beneficiaries only a one-time opportunity to enroll

without penalty. (If beneficiaries delayed enrollment, they

would pay a penalty related to their expected benefit costs

when they signed up.) Without that provision, CBO

would assume much lower rates of enrollment and much

higher costs per enrollee for each proposal, because people

would tend to postpone signing up for the benefit until

their drug spending became relatively high.

The Clinton Administration’s Plan. The proposal included in the Clinton Administration’s 2000 Mid-Session

Review called for a Medicare drug benefit that would have

no deductible and would pay 50 percent of an enrollee’s

drug spending up to a limit of $1,000 in 2005 (see Summary Table 1). Once a participant incurred $4,000 in

out-of-pocket costs during the year, Medicare would

cover 100 percent of further drug spending. Under the

proposal, plans would have the flexibility to vary their

enrollees’ coinsurance rates if they could demonstrate that

the lower cost sharing would not raise costs for the Medicare program; that is, more-generous benefits would be

offset by more-effective cost management.

The Secretary of Health and Human Services (HHS)

would set a uniform national premium for the drug benefit. Enrollees with income of up to 150 percent of the

federal poverty level would receive assistance in paying

their premiums; those with income of up to 135 percent

of the poverty level would also get help in paying their

cost-sharing amounts. In addition, Medicare would offer

a subsidy to employment-based health plans to encourage

them to remain the primary payer for their retirees’ drug

coverage. (That subsidy would equal 67 percent of the

amount that Medicare would have paid if a plan’s retirees

had enrolled in the Part D benefit.)

With those provisions, the general federal subsidy for all

enrollees would equal 50 percent of “premium costs” (the

total value of the benefits paid out plus the cost of administering the drug program) below the stop-loss limit. That

subsidy would be 100 percent above the limit.

Under the Clinton Administration’s proposal, PBMs or

other entities would compete to be the sole Medicare

drug plan in each geographic area for a specified period of

time. PBMs would not bear insurance risk for their enrollees’ drug spending, and they would face restrictions

on the cost-management approaches they could use. For

example, they would have to set dispensing fees high

enough to ensure participation by most retail pharmacies.

In addition, enrollees would be guaranteed access to any

drug that the prescribing physician certified as medically

necessary.

The Robb Amendment. Unlike the other proposals examined in this study, the Robb amendment would not cap

an enrollee’s benefits. Under that amendment, enrollees

would pay a $250 deductible and graduated coinsurance

rates—50 percent until their annual out-of-pocket drug

spending reached $3,500, then 25 percent until their outof-pocket spending reached $4,000. After that, Medicare

would cover all of their additional drug spending. The

entities selected to administer the benefit would be allowed to waive the deductible for generic drugs and to

lower beneficiaries’ coinsurance rates if they could show

that the lower cost sharing would be offset by effective

cost management.

Like the Clinton Administration’s plan, the Robb amendment would have the Secretary of HHS set a uniform

nationwide premium. The proposal would also provide

low-income subsidies to cover premiums and cost sharing

for enrollees with income of up to 135 percent of the

poverty level and premium assistance for people with

income of up to 150 percent of the poverty level. The

Robb amendment would offer the same subsidy as the

Clinton proposal to employment-based health plans if

they remained the primary source of drug coverage for

their retirees. The general subsidy for all enrollees would

equal 50 percent of premium costs.

Unlike the Clinton Administration’s proposal, however,

the Robb amendment envisions a competitive system,
SUMMARY xvii

6XPPDU\ 7DEOH 

Provisions of Four Prescription Drug Proposals for Medicare

Clinton

Mid-Session 

Review Plan

Robb

Amendment H.R. 4680

BreauxFrist II

Benefit Amounts (Dollars)a

Deductible None 250 250 250

Benefit cap 1,000 None 1,050 1,050

Stop-loss amount 4,000 4,000 6,000 6,000

Benefit Administrator SSA SSA Plans SSA

Subsidies for Employment-Based

Health Plans Yes Yes Nob Nob

Number of Plans in Each Region One At least two At least two At least two

Plans Bear Insurance Risk No No Yes Yes

Federal Subsidy for All Enrolleesc 50% subsidy of

premium costs

below stop-loss

amount; 100% above

50% subsidy of 

premium costs

No subsidy of

premium costs;

graduated 

reinsurance rate, 

averaging 35%d

25% subsidy of

premium costs

below stop-loss

amount; 80%

reinsurance above

Source: Congressional Budget Office.

Note: SSA = Social Security Administration.

a. The amounts that would apply in the Medicare drug benefit’s first year of operation, which is assumed to be calendar year 2005.

b. Employment-based health plans for retirees could participate as entities that provide a Medicare drug plan, with the same federal subsidy as other plans.

However, no attempt was made to estimate what share of total enrollment in the drug benefit they would account for.

c. “Premium costs” refers to the total value of the benefits paid out plus the cost of administering the drug program.

d. Today, the enrollee spending levels specified in H.R. 4680 at which federal reinsurance would be paid would lead to a federal subsidy of more than 35 percent.

However, the legislative language caps that subsidy at 35 percent. Thus, the spending levels at which the federal government paid reinsurance would need to be

raised.

with at least two entities (selected through competitive

bidding) administering the drug benefit in each region.

Those entities would not bear insurance risk for their

enrollees’ drug spending. They would also have fewer

explicit restrictions on the tools they could employ to

control drug spending than under the Clinton plan. For

example, PBMs could use restrictive formularies, subject

to rules set by a national committee. However, they

would have to provide any drug approved for marketing

in the United States if it was medically necessary for a

patient (as established through procedures set by the

PBM).

H.R. 4680. This proposal, which the House of Representatives passed in October 2000 but the Senate did not

consider, also envisioned a drug benefit with a $250 deductible. Medicare would pay 50 percent of participants’

drug costs, up to a cap of $1,050 in the first year of the

benefit. Once enrollees incurred out-of-pocket costs of

$6,000 or more during the year, Medicare would cover

100 percent of their drug spending. H.R. 4680 would

allow participating plans to offer actuarially equivalent

versions of the standard benefit—subject to certain limits.

Multiple plans would compete for enrollees in each region on the basis of premiums, access to drugs, and quality of services (once they were approved by the agency

administering the program through a process of negotiation). Unlike the two proposals discussed above, H.R.

4680 would require those plans to assume significant
xviii ISSUES IN DESIGNING A PRESCRIPTION DRUG BENEFIT FOR MEDICARE

insurance risk. It would also allow them to use a broad

array of tools to control their enrollees’ drug spending.

The federal government would ensure that at least two

plans were available in each area, one of which could be a

Medicare+Choice plan offering drug coverage. Employment-based health plans for retirees would also be eligible

to participate directly as entities themselves. In any area

not served by at least two plans, Medicare would have

authority to provide financial incentives (such as a partial

underwriting of risk) to encourage plans to operate in that

region.

Rather than having one nationwide premium set by

Medicare, H.R. 4680 would allow entities to set their

own premiums. As a result, premiums would vary geographically and among plans. Low-income subsidies

would cover premiums and cost-sharing expenses for

enrollees with income of up to 135 percent of the poverty

level (except that those enrollees would be responsible for

covering any spending in the hole between the benefit cap

and the stop-loss amount). Enrollees with income of up

to 150 percent of the poverty level would be eligible for

assistance with their premiums.

Unlike in the other proposals, the federal government

would not provide an across-the-board subsidy of each

plan’s premium. Instead, it would make reinsurance payments to plans for the spending of very high cost enrollees. In total, those payments would amount to 35

percent of the cost of benefits paid out under the drug

program.

Breaux-Frist II. This proposal has the exact same benefit

structure as H.R. 4680 and a similar subsidy for lowincome enrollees. However, its provisions for the general

federal subsidy for all enrollees differ. Whereas H.R. 4680

would provide all of that subsidy through individual reinsurance payments for high-cost enrollees, Breaux-Frist II

would subsidize 25 percent of premium costs below the

$6,000 catastrophic stop-loss limit and then cover 80

percent of benefits above that limit through individual

reinsurance.

Multiple risk-bearing plans would offer the benefit in

each region, and premiums could vary geographically and

among plans. In addition, PBMs would have the same

incentives and authority to manage costs under this proposal that they would have under H.R. 4680. However,

unlike in H.R. 4680, the Social Security Administration

would administer enrollment and collect premiums. As a

result, plans’ marketing and enrollment costs would be

lower under this proposal than under H.R. 4680.

6XPPDU\ 7DEOH 

Federal Costs of Four Prescription Drug Proposals, 2005-2012

(By fiscal year, in billions of dollars)

Clinton

Mid-Session

Review Plan

Robb

Amendment H.R. 4680

BreauxFrist II

Federal Mandatory Spending on Prescription

Drug Benefits for Medicare Beneficiaries

Medicare 507 342 120 178

Other federal programsa -145 -142 -84 -78

Low-income subsidy 128 148 141 123

Other Mandatory Spending 22 27 18 10

Total 512 374 195 233

Source: Congressional Budget Office.

Note: These numbers exclude a small amount of appropriated funds for federal administrative costs.

a. Principally Medicaid, the Federal Employees Health Benefits program, and the military’s Tricare for Life program. Negative numbers indicate savings.
SUMMARY xix

Range of Cost Estimates for the Four Proposals 

To estimate the costs of a proposed Medicare drug benefit, CBO uses a model that simulates how that benefit

would affect the spending of a representative sample of

Medicare beneficiaries. The model contains detailed information about Medicare beneficiaries’ spending for

prescription drugs and other health services, their supplemental insurance coverage, their health status, and their

income. CBO’s cost estimates result from running the

model using a proposal’s total design specifications; because the various design elements affect one another, the

impact of specific design choices on costs cannot be quantified independently.

Among the four proposed drug benefits examined here,

CBO estimates that the Clinton Administration’s would

have the highest costs to the federal government: a total of

$512 billion between 2005 and 2012 (see Summary

Table 2). That total reflects the federal costs of the new

Medicare benefit, including subsidies for low-income

enrollees, partly offset by federal savings in other programs, such as Medicaid, the Federal Employees Health

Benefits program, and the military’s Tricare for Life program. The Robb amendment would rank second in federal costs, at $374 billion over the same eight-year period.

Breaux-Frist II and H.R. 4680 would cost $233 billion

and $195 billion, respectively, during the 2005-2012

period. Although those two proposals have identical benefit structures, they differ in terms of the share of total

costs subsidized by the federal government. As a result,

their levels of enrollment would differ as well as their

federal costs.

The federal costs of a particular drug benefit depend

largely on the extent to which it subsidizes total drug

spending by or for Medicare beneficiaries. Thus, the

Robb and Clinton plans—which would pay 21 percent

and 29 percent, respectively, of Medicare beneficiaries’

total drug costs—would have the highest costs to Medicare. H.R. 4680 and Breaux-Frist II—which would pay

for 12 percent to 15 percent of total drug spending by or

for Medicare beneficiaries—would have lower costs to the

Medicare program.

Introduction

0edicare offers broad insurance protection for

many health needs of the nation’s elderly. However, it

provides very limited coverage for the costs of outpatient

prescription drugs (those not dispensed during a hospital

stay). That gap in coverage has become increasingly significant over the past three decades for a number of reasons. Prescription drugs have assumed growing importance in the treatment of disease, especially as new, more

effective—and more costly—drugs have become available

to treat chronic diseases prevalent in older people. Partly

as a result, spending for outpatient prescription drugs has

soared.

Despite Medicare’s limited drug coverage, most beneficiaries have not faced the full effects of that rapid rise in

spending. The reason is that roughly three-quarters of

Medicare beneficiaries have insurance coverage for outpatient prescription drugs through other sources. Those

sources include private insurance plans—such as employment-based plans for retirees and medigap plans that are

specifically designed to supplement Medicare—as well as

public programs, such as Medicaid. Some managed care

plans in the Medicare+Choice program also offer drug

coverage as an extra benefit, usually for an additional

premium. In general, the Medicare beneficiaries who lack

supplemental drug coverage or who have only limited

coverage are people in the low to middle part of the

income scale.

Policymakers have shown widespread interest in providing a comprehensive drug benefit through the Medicare

program. They cite various goals for such a benefit, some

of which may be mutually incompatible:

 Ensuring that all Medicare beneficiaries have access to

drug coverage,

 Offering coverage that is relatively comprehensive and

that reimburses some costs for most enrollees,

 Providing insurance protection for elderly people with

the highest drug spending,

 Ensuring that premiums are affordable, and

 Limiting the cost to the federal government.

The extent to which particular policy goals are met will

depend largely on how the Medicare drug benefit is designed. Even seemingly minor differences in specific design features can have a big impact on the drug program’s

cost to the federal government, its impact on total spending for prescription drugs, and the level of insurance protection it affords enrollees. Moreover, different design

features could have complex interactions. A clearer understanding of those differences and interactions would permit policymakers to better balance the trade-offs inherent

in a Medicare prescription drug benefit, such as the tradeoff between higher costs and greater insurance coverage.

The Congressional Budget Office (CBO) has grappled

with many of those issues in estimating the costs of Medicare drug programs proposed during the past three sessions of Congress. This study summarizes the key design

choices facing policymakers and explores the implications

of those choices for cost and coverage. It also discusses

CBO’s cost estimates for four Medicare drug proposals

first introduced in 1999 or 2000 during the 106th Congress. Those proposals are the one in the Clinton

Administration’s June 2000 Mid-Session Review; the Robb

amendment (introduced by Senator Charles Robb as

amendment 3598 to H.R. 4577); H.R. 4680 (introduced

by Representative William Thomas), which passed the
2 ISSUES IN DESIGNING A PRESCRIPTION DRUG BENEFIT FOR MEDICARE

2000 2005 2010 2015 2020 2025 2030

0

2

4

6

8

10

12

14

16

Medicaid

Medicare

Social Security

House of Representatives in October 2000; and BreauxFrist II (S. 2807, introduced by Senator John Breaux).

Those four proposals cover a broad spectrum of approaches for delivering a Medicare drug benefit. Each

year, when CBO updates its 10-year projections of drug

spending by or for Medicare beneficiaries, it also updates

its estimates for those proposals as a way to reassess key

assumptions used in its estimating models.

One issue surrounding a prescription drug benefit is

whether it should be a freestanding addition to Medicare

(referred to as a stand-alone benefit) or part of a broad

effort to restructure the program. Some policymakers

advocate expanding Medicare benefits only as one element of a more-sweeping reform that would change costsharing rules, introduce competitive features, and add

prescription drug coverage as an integrated benefit.

U.S. demographic pressures mean that without major

changes in Medicare’s design and financing, the cost of

the program will grow dramatically over the next 30 years

as the large baby-boom generation becomes eligible for

benefits.1

 At the same time, Social Security and Medicaid

will face an explosion in costs for the same reason (see Figure 1). Consequently, without significant changes, the

amount that the federal government spends on those

three programs is projected to consume a substantial portion of what it now spends on the entire budget.

Broad proposals to reform Medicare raise issues that go

well beyond those raised by proposals for a stand-alone

drug benefit. This study does not address those wider

issues. Rather, it focuses on several important questions

concerning a freestanding drug benefit that would be

available to beneficiaries under the present Medicare

system, including people enrolled in fee-for-service Medicare or in Medicare+Choice plans. Many policy analysts

have argued that fully integrating a drug benefit into

Medicare and ensuring stable funding for the program in

the future can only be accomplished in the context of

)LJXUH 

Spending for Social Security, Medicare,

and Medicaid, 2000-2030

(Percentage of GDP)

Source: Congressional Budget Office based on its midrange assumptions about

growth of gross domestic product and program spending. For further

details, see Congressional Budget Office, The Budget and Economic

Outlook: Fiscal Years 2003-2012 (January 2002), Chapter 6.

comprehensive reform. Such reform is an important policy choice but is beyond the scope of this analysis.

Likewise, this study does not discuss other legislative initiatives that relate to prescription drugs but are not directly part of a Medicare drug benefit. For example, under current federal law, manufacturers of brand-name

drugs that wish to have their products reimbursed by

Medicaid must give that program the best price available

to most other purchasers. If the Congress made drug

prices for Medicare exempt from that rule, so that Medicare’s discounts from drugmakers would not affect

Medicaid’s best price, then Medicare might be able to

negotiate even lower prices. As a result, the cost of a

Medicare drug benefit could decline. In addition, changes

in policies governing how the Food and Drug Administration regulates such matters as the introduction of new

drugs, promotion and advertising for prescription drugs,

or reimportation of U.S.-made drugs that were first exported to other countries at lower prices could affect the

cost of a Medicare benefit. Although policymakers might

consider initiatives in those and other areas as possible

ways to save money, each change would raise a host of

issues unrelated to a Medicare drug benefit.

1. See the statement of Dan L. Crippen, Director, Congressional

Budget Office, “Projections of Medicare and Prescription Drug

Spending,” before the Senate Committee on Finance, March 7,

2002.
CHAPTER



Medicare Beneficiaries’ Drug Spending

and Coverage

6everal trends are fueling the drive to add a prescription drug benefit to Medicare. Spending for prescription drugs continues to be the fastest growing segment of health care costs. And although Medicare beneficiaries make up nearly 15 percent of the U.S. population,

they account for about 40 percent of that spending,

which means that increases in drug costs affect them disproportionately. Altogether, Medicare beneficiaries will

use nearly $87 billion of outpatient prescription drugs in

2002—an amount that is expected to grow by about 12

percent a year over the next decade (even without a drug

benefit in the Medicare program).

In terms of drug coverage, what was traditionally Medicare beneficiaries’ main source, employment-based health

plans for retirees, has been scaling back benefits in many

cases. An additional factor is that Medicare beneficiaries

with the highest and lowest income are more likely to

have drug coverage (private and public, respectively).

People in the low to middle part of the income scale are

less likely to have coverage; thus, they pay a higher-thanaverage proportion of their drug costs from their own

pockets.

Nevertheless, the fundamental issue inherent in the

debate about adding a drug benefit to Medicare may not

be one of providing for use of prescription drugs so much

as one of redistributing the cost of drugs away from the

people, companies, and government entities that now pay

for them. Currently, about three-quarters of Medicare

beneficiaries have some kind of insurance to help defray

the cost of drugs. The remainder, who have no drug

coverage, filled an average of 25 prescriptions in 1999,

the Congressional Budget Office estimates, compared

with an average of 32 prescriptions for Medicare beneficiaries who have drug coverage.

Beneficiaries’ Spending on

Prescription Drugs

In recent years, the growth of prescription drug spending

has far outpaced the growth of spending for other types of

health care. Between 1990 and 2000, for example, annual

spending on prescription drugs in the United States grew

nearly twice as fast as total national health expenditures

(which in turn grew significantly faster than the economy

during that period, and continues to do so). Moreover,

since the mid-1990s, drug spending has increased at a

double-digit rate each year.

For the U.S. population as a whole, three factors explain

most of that growth: the introduction of new and costlier

drug treatments, broader use of prescription drugs by a

larger number of people, and (until recently) lower costsharing requirements by private health plans. New brandname drugs tend to be much more expensive than older

drug therapies that treat the same disease. And even as

prescription drugs have become more costly, more people

have been using them, for several reasons. Many new

drugs provide better treatment or have fewer side effects

than older alternatives. At the same time, insurance coverage has made such drugs relatively affordable. In addition,

more people are aware of new drug therapies through

such sources as the Internet and the “direct-to-consumer”

advertising campaigns of pharmaceutical manufacturers.
4 ISSUES IN DESIGNING A PRESCRIPTION DRUG BENEFIT FOR MEDICARE

7DEOH 

Prescription Drug Spending and

Medicare Benefits per Beneficiary,

2003-2012

(By calendar year)

Spending per

Medicare 

Average

Annual

Beneficiary

(Dollars)

Percentage

Change,

2003 2012 2003-2012

Outpatient Prescription Drugsa 2,439 5,816 10.1

Medicare Benefitsb 6,775 10,794 5.3

Memorandum:

Gross Domestic Product

per Capita 37,900 55,800 4.4

Source: Congressional Budget Office’s March 2002 baseline projections.

Note: These numbers assume the continuation of the current Medicare program, with no outpatient prescription drug benefit.

a. Total spending per beneficiary on outpatient prescription drugs not currently

covered under Medicare, regardless of payer.

b. Benefits and administrative costs per beneficiary under the Hospital Insurance and Supplementary Medical Insurance programs.

CBO expects prescription drug spending by Medicare

beneficiaries (or their health plans) to rise rapidly over the

next decade—at an average rate per person of 10.1 percent a year (see Table 1).1

 That rate is significantly faster

than the projected growth of spending for current Medicare benefits, and more than twice as fast as the expected

per capita growth of the U.S. economy. Medicare beneficiaries, employers who offer health coverage for retirees,

and state governments have pushed for a Medicare drug

benefit to obtain some financial relief from those rising

expenditures. 

Distribution of Beneficiaries’

Drug Spending

Although most Medicare beneficiaries use some prescription drugs, the bulk of drug spending is concentrated

among a relatively small group. A large share of that

spending pays for the treatment of chronic conditions,

such as hypertension, cardiovascular disease, and diabetes.

The skewed distribution of spending—and the need for

people with chronic conditions to stay on drug therapies

for a long time—makes voluntary stand-alone drug coverage particularly susceptible to the problem of adverse

selection, in which enrollment in an insurance plan is

concentrated among people who expect to receive more

in benefits than they pay in premiums. (That problem is

discussed in detail in Chapter 3.)

CBO projects that prescription drug spending by or for

Medicare beneficiaries will total more than $128 billion

in 2005 (the first year in which Medicare could probably

begin implementing a prescription drug benefit that was

enacted in 2002). In that year, about 64 percent of Medicare beneficiaries will spend over $1,000 on prescription

drugs, CBO estimates; their combined spending will

make up 96 percent of total drug expenditures by Medicare beneficiaries (see Table 2). Only 17 percent of beneficiaries are expected to spend more than $5,000 on pre7DEOH 

Prescription Drug Spending by or for

Medicare Beneficiaries, 2005

Spending Level

per Beneficiary

(Dollars)

Percentage of

Beneficiaries with

Spending Above

That Levela

Percentage of

Beneficiaries’

Total Drug

Spendingb

0 89.8 100.0

500 75.1 98.9

1,000 64.4 96.1

2,000 47.4 87.5

3,000 33.7 75.8

4,000 24.5 64.8

5,000 17.3 53.7

6,000 12.4 44.5

7,000 9.3 37.6

8,000 6.9 31.5

9,000 5.5 27.2

10,000 4.3 23.4

Source: Congressional Budget Office’s March 2002 baseline projections.

Note: These numbers do not include spending for outpatient prescription

drugs currently covered by Medicare.

a. Total Medicare enrollment for 2005 is projected to be 41.9 million people.

b. Beneficiaries’ total spending for outpatient prescription drugs in 2005 is

projected to be $128.1 billion. 1. That estimate assumes the continuation of the current Medicare

program, with no outpatient prescription drug benefit.
CHAPTER ONE MEDICARE BENEFICIARIES’ DRUG SPENDING AND COVERAGE 5

)LJXUH 

Sources of Payment for Medicare Beneficiaries’ Prescription Drugs, 1999

Source: Congressional Budget Office based on data from the 1999 Medicare Current Beneficiary Survey.

Note: HMOs = health maintenance organizations.

a. These are generally also employment-based plans.

scription drugs in 2005, but their spending will make up

nearly 54 percent of the total.

Beneficiaries’ Existing Drug Coverage

Certain factors suggest that growth in drug spending has

a larger financial impact on Medicare beneficiaries than

on other segments of the population. On average, 40 percent of Medicare beneficiaries’ drug expenditures came

from their own pockets in 1999 (the most recent year for

which data are available), compared with about 33 percent for the U.S. population as a whole (see Figure 2).

Also, because Medicare beneficiaries are elderly or disabled, they are more likely to have chronic health conditions and to use more prescription drugs: nearly 90 percent filled at least one prescription in 1999, compared

with just over 60 percent of the population as a whole.

Medicare beneficiaries made up nearly 15 percent of the

population that year, but they accounted for about

40 percent of spending on outpatient prescription drugs

in the United States.

Overall statistics, however, mask a wide variety of personal circumstances. In 1999, one-quarter of the Medicare population had no prescription drug coverage. The

other three-quarters of beneficiaries obtained drug coverage as part of a plan that supplemented Medicare’s benefits. But those supplemental plans differed greatly in the

extent of drug coverage they provided.

Employment-Based Plans

Traditionally, more elderly people have received prescription drug coverage from retiree health plans than from

any other source. In 1999, about 30 percent of Medicare

beneficiaries had supplemental health insurance through a

current or former employer, and most of those health

plans covered prescription drugs (see Table 3). Although

specific benefits vary, employment-based drug coverage
6 ISSUES IN DESIGNING A PRESCRIPTION DRUG BENEFIT FOR MEDICARE

7DEOH 

Medicare Beneficiaries’ Prescription Drug Coverage, 1999

Type of Drug Coverage

Number of Medicare

Beneficiaries with

That Coverage

(Millions)

Percentage of

All Medicare

Beneficiaries

Average

Number of

Prescriptions

Filled

Medicaida 6.4 15.9 39

Employment-Based Plan 11.9 29.6 31

Individually Purchased (Medigap) Policy 4.5 11.2 32

Other Public Coverageb 1.7 4.1 37

HMO Not Elsewhere Classifiedc 5.7 14.2 28

Subtotal 30.2 75.0 32

No Drug Coverage 10.1 25.0 25

Total 40.4 100.0 30

Source: Congressional Budget Office based on data from the 1999 Medicare Current Beneficiary Survey.

Note: Some Medicare beneficiaries have more than one type of coverage for outpatient prescription drugs. The categories in this table are mutually exclusive, and

CBO assigned people to categories in the order shown above.

a. Beneficiaries who received any Medicaid benefits during the year, including those eligible for a state’s full package of benefits (so-called dual eligibles and people

who meet eligibility requirements after paying their Medicaid expenses).

b. Beneficiaries who received aid for their drug spending through state-sponsored pharmaceutical assistance programs, the Department of Veterans Affairs, the

Department of Defense, or health maintenance organizations under Medicare+Choice nonrisk contracts.

c. Primarily health maintenance organizations under Medicare+Choice risk contracts.

tends to feature relatively low deductibles and copayments.

Many employers have begun to restructure their benefits,

however, because prescription drug spending by elderly

retirees has become a significant cost. A 1997 study by

Hewitt Associates for the Kaiser Family Foundation

found that among large employers, drug spending for

people age 65 or older constituted 40 percent to 60 percent of the total cost of their retiree health plans.2

 Average

use of prescription drugs among elderly retirees was more

than double that of current workers. Although relatively

few employers in the Hewitt survey had dropped retiree

coverage altogether, most had taken steps to control costs,

such as tightening eligibility standards, requiring retirees

to pay a greater share of their premiums, placing caps on

the amount of benefits that plans will cover, and encouraging elderly beneficiaries to enroll in managed care

plans.

Other Sources of Drug Coverage

Another way in which elderly or disabled people can obtain prescription drug coverage is through Medicare+

Choice (M+C) plans. In 2002, 50 percent of Medicare

beneficiaries have access to M+C plans that offer some

drug coverage. But a far smaller fraction of beneficiaries,

about 9 percent, sign up for those plans. In addition,

many M+C plans have scaled back their drug benefits in

response to higher drug costs and slower growth in Medicare’s payment rates. Nearly all such plans have annual

caps on enrollees’ drug benefits, and a growing percentage

charge a premium for supplemental benefits. Some plans

limit their coverage to generic drugs, with no coverage for

brand-name prescriptions.

About 23 percent of the Medicare population relied on

individually purchased (medigap) plans as their main

2. Hewitt Associates, Kaiser Medicare Policy Project, Retiree Health

Trends and Implications of Possible Medicare Reforms (Washington,

D.C.: Hewitt Associates, September 1997), available at www.kff.

org/content/archive/1318/retiree_r.html.
CHAPTER ONE MEDICARE BENEFICIARIES’ DRUG SPENDING AND COVERAGE 7

form of supplemental health coverage in 1999, but less

than half of that group had policies that covered prescription drugs. Medigap plans with drug coverage tend to be

much less generous than retiree health plans: they have an

annual deductible of $250, require cost sharing of 50 percent, and limit yearly benefits to either $1,250 or $3,000.

Premiums for medigap plans that include drug coverage

also tend to be much higher than premiums for other

medigap plans, in part because of their tendency to attract

enrollees who have higher-than-average health expenses.

Some low-income Medicare beneficiaries are eligible for

Medicaid coverage, which generally includes a prescription drug benefit. All state Medicaid programs offer drug

coverage (usually with little or no cost sharing) to people

whose income and assets fall below certain thresholds. In

addition, as of September 2002, 34 states had authorized

(though not necessarily begun implementing) some type

of pharmaceutical assistance program. Many of those

programs will provide direct aid for drug purchases to

low-income elderly people who do not meet the eligibility

requirements for Medicaid. In all, about 76 percent of the

Medicare population lives in those states.

On average, Medicare beneficiaries with drug coverage

had about 32 prescriptions filled in 1999. Those without

drug coverage used fewer prescription drugs that year, but

they still had an average of 25 prescriptions filled.

Differences by Income Level

Many middle- and higher-income seniors can obtain

coverage through retiree plans, and seniors with the lowest income generally have access to state-based drug benefit programs. However, Medicare beneficiaries with income between one and three times the federal poverty

level tend to be caught in the middle: they are less likely

than poorer seniors to qualify for state assistance and less

likely than higher-income seniors to have access to drug

coverage through former employers. In 1999, nearly half

of Medicare beneficiaries had income between one and

three times the poverty level, and almost 30 percent of

them had no drug coverage (see Table 4). People in those

income groups paid more of their drug costs out of

pocket than other Medicare beneficiaries did (44 percent

versus 34 percent).

7DEOH 

Medicare Beneficiaries’ Prescription Drug Coverage and Spending,

by Income Level, 1999

Percentage Spending on Outpatient

Number of Percentage of Income Prescription Drugs

Income Relative Medicare of All Group (Billions of dollars)

to the Federal Beneficiaries Medicare Without Drug Total Out-of-Pocket 

Poverty Level (Millions) Beneficiaries Coverage Spending Spending

Less Than 100 Percent 6.6 16.2 20.0 8.3 2.0

100 to 200 Percent 11.4 28.2 31.4 13.4 5.8

200 to 300 Percent 8.1 20.1 25.5 9.6 4.2

300 Percent or More 14.3 35.4 22.0 19.3 7.4

Total 40.4 100.0 25.0 50.5 19.4

Source: Congressional Budget Office based on data from the 1999 Medicare Current Beneficiary Survey.

Note: CBO adjusted each beneficiary’s level of drug spending by 25 percent to reflect underreporting in the survey. Prescription drug spending for survey respondents in nursing homes was imputed from the spending of noninstitutionalized respondents who have trouble with the same number of activities of daily living.

CHAPTER



Design Choices for a

Medicare Drug Benefit

,n designing a drug benefit for Medicare, policymakers must make four fundamental decisions:

 How comprehensive will the coverage be?

 Who will be eligible to enroll?

 To what extent will the government pay enrollees’

costs?

 How and by whom will the drug program be administered?

The answers to each of those questions will have a major

impact on the program’s cost to the federal government

and to enrollees. (This chapter and the next describe, in

general, how various approaches to those choices affect

costs. Specific cost estimates for particular proposals are

discussed in Chapter 4.)

In addition, most of those decisions will involve trade-offs

among the various goals for a Medicare prescription drug

benefit. For example, features designed to encourage wide

enrollment—such as extensive coverage, low deductibles

and copayments, broad eligibility, and subsidies for lowincome enrollees—will also make the program more expensive for the federal government (and possibly for state

and local governments). But features designed to control

costs—such as narrow coverage, high cost sharing by enrollees, and limited eligibility—may mean that fewer

Medicare beneficiaries receive the benefits of prescription

drug coverage.

Any program in which the federal government subsidizes

a large share of drug costs for many enrollees will require

substantial federal outlays. Medicare beneficiaries are expected to spend an average of nearly $2,500 apiece on

outpatient prescription drugs in 2003. Access to better

drug coverage would undoubtedly stimulate further

spending. However, decisions about how to administer

the drug benefit can exacerbate or alleviate the federal cost

burden. Consequently, those decisions are especially important.

All of the recent proposals for a Medicare drug program

would rely on private entities to administer the benefit,

but there are significant differences in the functions envisioned for those entities. Opportunities exist to manage

drug use and prices prudently, but pharmacy benefit

managers need both the incentives and the tools to do so.

The Congressional Budget Office has concluded that

among the designs for a Medicare drug program proposed

in the past few years, those with certain administrative

features offer the greatest opportunity for constraining

federal costs and total spending on outpatient prescription drugs. Although not without shortcomings, those

designs have three main features: they allow benefit managers to employ the full array of tools now used to administer private-sector drug plans, they force benefit managers to compete among themselves for enrollees’ business,

and they make managers assume financial risk for delivering benefits.
10 ISSUES IN DESIGNING A PRESCRIPTION DRUG BENEFIT FOR MEDICARE

Taxpayers'

share

$0 $3,000 $12,000 $6,000 $9,000

$250

deductible

Stop-loss protection after enrollee's 

out-of-pocket spending reaches $6,000

50%

coinsurance

100%

coinsurance

in the "hole"

Enrollees'

premiums

Taxpayers' share

Enrollee's Annual Drug Costs

Enrollees'

premiums

Taxpayers'

share

)LJXUH 

Hypothetical Structure of a Medicare Prescription Drug Benefit

Source: Congressional Budget Office.

The Structure of the Coverage

The single biggest determinant of the cost of a Medicare

drug benefit is how the coverage is designed. Choices

about the structure of the coverage include:

 The deductible amount (whether coverage begins with

the first dollar of drug spending in a given year or after

the deductible amount is reached);

 Cost-sharing rates (what share of the cost of a prescription is the responsibility of the enrollee);1

 The benefit cap (the level of spending beyond which

the enrollee must pay the full cost of each prescription); and

 The catastrophic stop-loss amount (the level of spending beyond which the enrollee pays little or nothing for

prescriptions).

The possible variations on those choices are numerous

and could produce benefits unlike anything available in

the private sector today. Of the four proposals discussed

in Chapter 4, the Clinton Administration’s plan and

H.R. 4680 both include a capped benefit, then a “hole” (a

level of spending at which there would be no drug coverage), and finally a stop-loss provision, beyond which the

benefit would pay all drug costs (see Figure 3). Plans currently available through employers, by contrast, almost

never include such holes in coverage. The larger the range

of spending encompassed by the hole, the less costly the

program would be—but also the less coverage the benefit

would provide. 

The structure of the coverage also indirectly affects the

cost of the drug program through the out-of-pocket

1. Cost-sharing rates can be specified as dollar amounts (copayments)

or as a percentage of costs (coinsurance).
CHAPTER TWO DESIGN CHOICES FOR A MEDICARE DRUG BENEFIT 11

spending it requires of enrollees. Benefits with low costsharing rates would encourage enrollees who were newly

shielded from paying the full costs of their drugs to use a

greater number of—and more expensive—prescriptions.

Conversely, higher cost-sharing rates would induce less

new drug spending.

Eligibility for Enrollment

A fundamental design choice concerns whether the prescription drug benefit would be available to all Medicare

beneficiaries or only some (on the basis of such criteria as

income, wealth, or current drug coverage). The cost of

the drug program could be reduced by limiting eligibility.

However, most recent proposals for Medicare drug coverage would allow all Medicare beneficiaries to enroll, although they would provide much higher subsidies to lowincome beneficiaries.

A second choice for policymakers is whether to make enrollment in the benefit voluntary and, if so, with what

restrictions. A voluntary drug program that did not limit

when and how often an eligible person could enroll

would encourage beneficiaries to sign up only when they

expected to incur high drug costs and to opt out again

when they expected little need for prescription drugs. All

of the proposals examined in Chapter 4 would provide a

voluntary drug benefit, but they would restrict that choice

by giving people only one opportunity to enroll without

penalty (when they first became eligible), or by imposing

a surcharge on people who delayed enrollment, to reflect

the higher costs that such enrollees typically entail.

(When the drug program began, however, all Medicare

beneficiaries, regardless of age, would have a chance to

sign up for the coverage.)

Besides those two restrictions, another way to reduce

beneficiaries’ incentives to enroll or drop coverage at will

would be to couple the drug benefit with Part B of

Medicare (Supplementary Medical Insurance). In that

case, beneficiaries could choose either Part B plus drug

coverage or no Part B and no drug coverage. Because

Medicare currently pays 75 percent of Part B benefits,

and because enrollment in Part B without penalty is restricted to a brief period after eligibility begins, virtually

all Medicare beneficiaries sign up for Part B. Linking the

drug benefit to enrollment in Part B would probably

ensure reasonably high participation in the benefit. However, if enrollment in Part B required enrollment in the

drug program and the full premium (for Part B plus

drugs) rose substantially as a result, some people who

would otherwise enroll in Part B might drop that coverage.

The Level and Structure

of Federal Subsidies

Two important design choices are how much the federal

government would contribute to the cost of drug coverage for Medicare beneficiaries and how such subsidies

would be structured. Those design choices have consequences not only for federal costs but also for costs to

state and local governments. In addition, the level of subsidy offered to enrollees would have an important effect

on people’s willingness to take part in the drug program.

Most of the Medicare drug benefits proposed recently in

the Congress would provide some level of federal subsidy

for all enrollees, but they would still require those enrollees to contribute substantially—through both cost

sharing and premiums. To make drug coverage more

affordable to low-income Medicare beneficiaries, most

proposals would provide a higher federal subsidy for enrollees who met certain eligibility criteria.

Subsidies for All Enrollees

The higher the subsidy, the greater the number of people

who would want to enroll in a drug benefit, but also the

greater the costs to the federal government. Widespread

enrollment is desirable for two reasons: it means that the

drug benefit is accomplishing the goal of providing insurance to most Medicare beneficiaries, and it reduces the

likelihood that enrollees will be drawn disproportionately

from people who expect to have high drug costs. The

question for policymakers is, How large would the federal

subsidy have to be to induce most Medicare beneficiaries

to enroll?

Even if the federal subsidy was small, enrollment would

still be fairly high because many people with private or

public drug coverage would probably be required to enroll. For example, employment-based health plans would
12 ISSUES IN DESIGNING A PRESCRIPTION DRUG BENEFIT FOR MEDICARE

probably require retirees eligible for a Medicare drug

benefit to participate in it, just as they now effectively

require that retirees participate in Part B. Even employers

who offered to pay Medicare’s drug premium for retirees

would have lower costs so long as that premium was subsidized to any extent (assuming their retirees were not

markedly less costly than the average Medicare participant). The more comprehensive Medicare’s drug coverage

was, the more employers’ health care costs for retirees

would be reduced, but they would probably take advantage of even a limited drug benefit. Likewise, state Medicaid agencies, even if not required to do so, would choose

to enroll people eligible for both Medicare and Medicaid

in a Medicare drug program if states’ costs under the new

program were less than under Medicaid’s current drug

benefit.

Thus, the people whose participation would be most

sensitive to the size of the federal subsidy would be the

one-quarter of Medicare beneficiaries without drug coverage from private or public sources. If the drug benefit was

not subsidized and enrollment was always open, few of

those beneficiaries would be likely to enroll. If, however,

they had only one chance to enroll without financial penalty, some of those beneficiaries would probably take part

without any federal subsidy, and most would choose to

enroll at subsidy rates well below 100 percent of the cost.

The reason is that virtually all beneficiaries would expect

to receive more in benefits in some years than the premiums they paid. One-time-only enrollment would also

increase the extent of participation for any given level of

subsidy. However, a drug benefit that was financed

mainly by enrollees could be difficult for some people to

afford—specifically, people whose income or assets were

only slightly too high to qualify for drug coverage

through Medicaid or other public programs.

Subsidies for Low-Income Enrollees

Creating an additional subsidy program for low-income

users of a Medicare drug benefit requires making decisions about such things as eligibility for the subsidy, the

size of the subsidy, and whether states would pay a share.

Those choices would affect enrollment in the drug benefit

and its cost to the federal government and the states.

Who Would Be Eligible? As noted earlier, some lowincome Medicare beneficiaries receive assistance for part

or all of their medical costs through the federal/state

Medicaid program. Those beneficiaries fall into three

categories.

 Dual eligibles meet all state requirements for Medicaid

eligibility, either because their income and assets are

below the limits set by a state or because they have

“spent down” their resources to those limits as a result

of high medical costs (in which case they are referred to

as the medically needy). People in the first group have

their Medicare premiums and cost sharing paid by

Medicaid. They also receive all Medicaid benefits, including coverage for prescription drugs. Most medically needy beneficiaries receive the same benefits, although a few states do not cover their expenses for

drugs.

 Qualified Medicare beneficiaries (QMBs) have income

below the federal poverty level and meet certain restrictions on financial assets. About 75 percent of them

qualify as dual eligibles; the other 25 percent are eligible for benefits only as QMBs. That group has its

Medicare premiums and cost sharing paid by Medicaid

but is not eligible for other Medicaid benefits, such as

drug coverage.

 Specified low-income Medicare beneficiaries (SLMBs)

have income between 100 percent and 120 percent of

the federal poverty level and meet certain restrictions

on financial assets. About one-third of them qualify as

dual eligibles; the other two-thirds qualify only as

SLMBs. The sole benefit that SLMBs receive from

Medicaid is payment of their Medicare Part B premiums.

Most proposals for a Medicare drug benefit include some

form of low-income subsidy for beneficiaries in all of

those categories.

In addition, most recent Medicare drug proposals would

assist other low-income Medicare beneficiaries. Proposals

typically call for providing subsidies to all enrollees with
CHAPTER TWO DESIGN CHOICES FOR A MEDICARE DRUG BENEFIT 13

income below 135 percent of the poverty level (and limited assets), which would cover their premiums and cost

sharing for prescription drugs. Enrollees with income

between 135 percent and 150 percent of the poverty level

would have some or all of their premiums subsidized.

Many proposals would extend the subsidies to enrollees

with even higher income. (A few proposals would remove

limits on assets.)

How Much Would States Pay? A key design choice for

low-income subsidies is how much would be funded by

the federal government and how much by the states. The

federal government now pays 57 percent of Medicaid

costs, on average, with the states covering the rest. Some

proposals for a Medicare drug benefit would maintain the

current federal percentage for dual eligibles and QMBs.

However, the federal government would pay the full

subsidy for other low-income enrollees (those who met

special income and asset limits established for low-income

subsidies in the drug program). Other proposals would

require the federal government to pay the full cost of the

subsidies for all low-income enrollees, including dual

eligibles. In many of those cases, states would be required

to reimburse the federal government for some share of the

amount they saved under the proposal.

A proposal that increased the federal government’s share

of the cost of low-income subsidies would reduce states’

costs, and vice versa. The low-income subsidy would also

augment or (at the state’s option) replace state-run drug

programs for low-income seniors who are not eligible for

Medicaid. As noted earlier, 34 states either have introduced or are planning to introduce such programs. A

federal subsidy of Medicare beneficiaries in those programs would directly reduce state spending.

Who Would Participate? The cost of a low-income subsidy program would ultimately depend on how many

people participated. Not all eligible Medicare beneficiaries would choose to receive a low-income subsidy even if

they enrolled in the drug benefit. Some might want to

avoid being associated with a government “welfare” program; others might not believe that they were eligible for

or needed the subsidy.

What entity was chosen to administer the low-income

subsidy program could affect the level of participation.

CBO estimates that only 50 percent of people eligible for

QMB subsidies and 30 percent of those eligible for

SLMB subsidies take part in those programs today. Most

recent proposals for a Medicare drug benefit would rely

on state Medicaid agencies to determine eligibility and

enroll low-income beneficiaries—as the QMB and SLMB

programs do now. However, another option would be to

have the Social Security Administration (SSA) provide

those enrollment services. Participation would be higher

under that arrangement because less “welfare” stigma is

associated with SSA than with Medicaid.

As was the case with subsidies for all enrollees, the size of

the low-income subsidies would also influence participation. A larger subsidy would almost certainly induce more

people to take part in the low-income program.

That effect would also depend on the design of the

Medicare drug coverage. High deductibles or premiums

might persuade eligible low-income beneficiaries to sign

up for the low-income subsidy to cover those up-front

costs. Similarly, the more generous the coverage of drug

expenses beyond the deductible, the stronger would be

the incentive to enroll.

Perhaps the major issue affecting participation by lowincome beneficiaries is whether the asset standards now in

place for Medicaid would be relaxed for the Medicare

drug benefit. Most proposals would retain the asset standards currently used to determine QMBs and SLMBs.

However, less-stringent standards would expand the

number of people eligible for low-income subsidies.

The Effect on Spending for Medicaid. Adding prescription drug coverage to Medicare would alter not only federal spending for that program but also federal and state

spending for Medicaid. Such coverage would reduce

Medicaid’s costs for dual eligibles because Medicare

would pick up part of their prescription drug costs. However, some of that reduction would be offset by higher

enrollment in the Medicaid program. Some people who

are now eligible for Medicaid do not enroll; a Medicare
14 ISSUES IN DESIGNING A PRESCRIPTION DRUG BENEFIT FOR MEDICARE

drug benefit would give them a new incentive to do so,

because under most proposals, state Medicaid programs

would administer the low-income subsidies. Thus, people

applying for Medicare drug coverage under the low-income subsidy would learn about their eligibility for

Medicaid and enroll in that program at the same time.

Other Factors Affecting the Cost of Low-Income Subsidies. The effect on federal costs for low-income subsidies

would depend not just on the factors discussed above but

also on the interplay between the coverage provided by a

Medicare drug benefit and the provisions for low-income

subsidies. In general, increasing cost sharing for enrollees

in the drug benefit would lead to higher federal subsidies

for low-income enrollees. Conversely, reducing enrollees’

cost sharing would result in lower federal costs for lowincome subsidies.

Administrative Approach

The way in which a Medicare drug program was administered could also have a significant impact on its cost.

Most recent proposals envision the approach—now common in the private sector—of using organizations such as

pharmacy benefit managers (PBMs) to administer the

benefit. The proposals differ, however, in the number of

such organizations that would serve a region, the restrictions they would be subject to, the basis on which they

could compete for enrollees, and whether they would assume any insurance risk. (Insurance risk occurs when the

entity providing coverage is liable for payments that may

not be fully covered by premiums or reimbursements or,

conversely, is allowed to keep part of surpluses when costs

fall short of premiums or reimbursements.)

In the past decade, PBMs have come to play a central role

in administering prescription drug benefits in the private

sector (see Figure 4). Their main function is to act as a

health plan’s agent in administering a drug benefit. PBMs

do not distribute prescription drugs to patients, except

when they own mail-order or community pharmacies.

Instead, prescription drugs flow from manufacturers to

dispensing pharmacies (often with stops along the way at

wholesalers’ warehouses) and then to consumers, either at

pharmacies or by mail. A pharmacy pays a manufacturer

for the drugs it purchases and in turn charges a price it

has negotiated with the PBM. The consumer and health

plan share the responsibility for paying that price.

PBMs perform various functions and use various management tools. They process and pay claims. On behalf of a

health plan and its enrollees, they also negotiate price

discounts with dispensing pharmacies and rebates with

drug manufacturers. In return for receiving rebates,

PBMs try to steer enrollees toward preferred or formulary

drugs. (A formulary is a list of drugs that the health plan

will cover. Nonpreferred drugs are covered and therefore

included in the formulary, but they typically entail higher

cost sharing for the enrollee than preferred drugs do.)

PBMs’ other strategies for lowering costs include encouraging the use of generic drugs and dispensing drugs

through mail-order pharmacies, which many large PBMs

own. PBMs may establish and enforce differential costsharing requirements to encourage enrollees to select

lower-cost drugs. In addition, because they keep centralized records of each enrollee’s prescriptions, they can help

prevent inappropriate dosages and harmful drug interactions.2

Although PBMs in the private sector often have considerable leeway in the tools they can use, they do not assume

any insurance risk for the drug benefits they administer.

However, they may have a bonus added to, or a penalty

subtracted from, their administrative fee on the basis of

how well they meet preset goals for their performance.

Some of the Medicare drug proposals developed during

the 106th Congress, such as the Clinton Administration’s, called for a single PBM selected periodically to

serve each region, with all insurance risk borne by Medicare, not the PBM. Other proposals, such as H.R. 4680,

adopted a different approach: they would use multiple

risk-bearing entities (such as PBM/insurer partnerships)

that would compete to serve enrollees in each region. En2. See, for example, E.P. Armstrong and C.R. Denemark, “How

Pharmacists Respond to On-Line, Real-Time DUR Alerts,” Journal of the American Pharmaceutical Association, vol. 38, no. 2

(March-April 1998), pp. 149-154; and Stephen Soumerai and

Helene Lipton, “Computer-Based Drug-Utilization Review,” New

England Journal of Medicine, vol. 332, no. 24 (June 15, 1995), pp.

1641-1645. 
CHAPTER TWO DESIGN CHOICES FOR A MEDICARE DRUG BENEFIT 15

Consumer

Premiums

Health Plan

Pharmacy

Payment for health plan's

share of drug costs

PBM

Price discounts for enrollees

Drugs dispensed Cost-sharing amount Percentage of

manufacturer's 

rebates

Payment for drugs 

and administration

Wholesaler

Pharmaceutical

Manufacturer

Prescription drugs Payment for 

drugs (at a 

negotiated 

discount)

Rebates

)LJXUH 

The Role of PBMs in the Flow of Money and Prescription Drugs

Source: Congressional Budget Office.

Note: PBM = pharmacy benefit manager.

rollees would have some choice among entities, so people

who were willing to accept more restrictive rules (such as

a limited formulary) in return for lower cost sharing or

premiums could do so, while others could select a more

expensive plan with fewer restrictions. Hybrid models

have been proposed in which multiple entities would

compete for enrollees without bearing insurance risk.

They could compete on the basis of such features as lower

drug prices, fewer limits on covered drugs, and wider networks of pharmacies.

Each administrative model has its pros and cons. The

next chapter describes how each model addresses key

problems inherent in designing a Medicare prescription

drug program—such as the risk to plans from enrolling a

disproportionately large share of people with high expected drug costs, the need to control drug spending, and

the feasibility of administering the benefit efficiently.

CHAPTER



Problems in Designing

a Medicare Drug Benefit

$lthough the choices available to policymakers

seem numerous, many proposals for a Medicare prescription drug benefit have certain similarities. The reason is

that they are trying to address specific problems that arise

in designing such a benefit. Those problems include the

possibility that the coverage will mainly attract people

with the highest drug costs, the need to constrain total

costs to the government and to enrollees, the ability and

willingness of private entities (such as pharmacy benefit

managers) to administer the drug benefit, and the possible

side effects of the drug program on other parts of Medicare.

Selection Issues

Policies that would provide stand-alone prescription drug

benefits may be especially prone to the insurance-market

phenomenon known as adverse selection, in which people

who expect to have higher-than-average costs disproportionately enroll in an insurance plan. Adverse selection

becomes an issue when plans (or potential enrollees) make

decisions based on the desire to avoid attracting (or being

grouped with) enrollees who are likely to have expensive

claims. For example, the threat of adverse selection may

lead insurers to design or manage their plans in such a

way as to discourage people with high expected claims

from joining. Or they may market their plans in ways that

will avoid such enrollees. Similarly, potential enrollees

would prefer not to be put in an insurance pool with

people who were likely to have high costs, because that

would imply higher premiums than would otherwise be

the case. Thus, the potential for adverse selection might

cause some people to opt out of insurance altogether.

Adverse selection can occur in an insurance market if

subgroups of potential enrollees can be expected to use

benefits at a rate that will differ substantially from that of

other groups. In the case of prescription drugs, demand is

strongly related to whether a person has a chronic medical

condition. Thus, many Medicare beneficiaries may have a

good idea of their likely drug spending in the short run

and, in some cases, even in the long run. If the plan (or

plans) that offered Medicare drug coverage could not distinguish between enrollees with high or low expected

costs—or was not permitted to treat such enrollees differently in terms of benefits offered or premiums charged

—then adverse selection could occur in a voluntary drug

program. 

Why Is Adverse Selection a Problem?

Adverse selection poses difficulties in several ways. It

undermines the purpose of health insurance, which is to

spread among a pool of people the financial risks that

would arise if some of them developed medical problems.

Adverse selection raises the cost of insurance for people

who do enroll. And it makes people who do not enroll

worse off by not receiving the benefits of insurance. (Even

people who anticipate having low medical costs could

benefit from insuring against the possibility that they

develop an unexpected illness.)
18 ISSUES IN DESIGNING A PRESCRIPTION DRUG BENEFIT FOR MEDICARE

In private insurance markets, adverse selection can create

a pattern of high premiums and low enrollment, resulting

in much less coverage than would otherwise have been the

case.1

 The history of private medigap policies that cover

outpatient prescription drugs is a case in point. A variety

of insurers sell medigap policies to Medicare beneficiaries

who typically lack other sources of supplementary coverage. Since 1992, insurers have been allowed to market

only 10 standardized medigap policies, and an insurer

must charge the same premium for a given policy to all

beneficiaries who enroll when they first become eligible

for Medicare. Premiums can rise with a policyholder’s age

but cannot vary according to his or her health status.

Three of the 10 medigap policies available to Medicare

beneficiaries include some coverage of prescription drugs.

However, that coverage is limited by benefit caps. Even

so, those plans are costly compared with medigap plans

that exclude drugs.2

 Most experts agree that the reason for

the higher costs is that people who buy the drug policies

are more likely to use prescription drugs than people who

do not.3

 Today, only 8 percent of Medicare beneficiaries

with standardized medigap policies are enrolled in any of

the three plans that provide drug coverage.4

Two kinds of adverse selection can affect the operation of

a Medicare drug benefit: adverse selection into the drug

program as a whole, and, if multiple plans are allowed to

administer the drug benefit in the same region and bear

financial risk for their costs, adverse selection among

those plans. 

Adverse Selection Into the Overall Drug Program

If relatively healthy Medicare beneficiaries (such as those

with no chronic conditions) tended to opt out of drug

coverage, the result would be higher per capita costs and

premiums for enrollees than would be the case if the benefit covered a representative mix of Medicare beneficiaries. Moreover, if people could enroll or unenroll in the

drug program at any time, some would go from paying

no premium when healthy (and paying drug expenses out

of pocket if an acute condition developed) to enrolling

and paying a high premium when they developed a condition requiring treatment with prescription drugs.5

 Such

1. In an extreme situation, adverse selection can lead to the absence

of an insurance market for some types of risks. For example, in the

individual insurance market, health plans will not cover people

who have been diagnosed with certain conditions (or will not cover

services for those conditions) even though they could charge such

people a higher premium; see Joseph P. Newhouse, “Reimbursing

Health Plans and Health Providers: Efficiency in Production Versus Selection,” Journal of Economic Literature, vol. 34 (September

1996), pp. 1236-1263. Researchers have constructed models of

the insurance market in which, given the choice between a managed care plan and a fee-for-service plan, more people join the

managed care plan than would do so in the absence of selection

issues. That happens because the relative premiums of the two

types of plans are affected by the health risks of the people who

join the plans. If healthier people, on average, prefer a managed

care plan, that plan’s premiums will be lower than they would

have been solely on the basis of any efficiency advantage of the

managed care plan. See Roger Feldman and Bryan Dowd, “Risk

Segmentation: Goal or Problem?” Journal of Health Economics, vol.

19 (2000), pp. 499-512.

2. Lauren A. McCormack and others, “Medigap Reform Legislation

of 1990: Have the Objectives Been Met?” Health Care Financing

Review, vol. 18, no. 1 (Fall 1996), pp. 157-174.

3. People with drug coverage may have higher drug spending than

other people for two reasons: adverse selection and the utilization

effect of insurance (known as moral hazard in the economics literature). The utilization effect refers to people’s greater willingness to

spend money on something, such as prescription drugs, when the

price they pay has been lowered because of their insurance. The

literature on medigap coverage has emphasized adverse selection as

the more important reason for high drug spending in medigap

policies that cover prescription drugs.

4. See General Accounting Office, Medigap Insurance: Plans Are

Widely Available but Have Limited Benefits and May Have High

Costs, GAO-01-941 (July 2001). That estimate does not include

the 40 percent of existing medigap policies that either were issued

before benefits were standardized in 1992 or are otherwise exempt

from the federal standards. Some of those older policies include

prescription drug coverage.

5. Even with some adverse selection, however, the drug benefit could

still offer a significant degree of insurance as long as the frequency

with which a person could enroll or unenroll was limited in some

way. Future medical costs can rarely be predicted accurately, so a

drug benefit would help insure against uncertainty even for enrollees with chronic illnesses.
CHAPTER THREE PROBLEMS IN DESIGNING A MEDICARE DRUG BENEFIT 19

behavior would undermine the value of health insurance,

which depends on collecting premiums from people while

they are healthy so that enough funds are available to pay

the bills of people who face medical expenses.

Paradoxically, although adverse selection into the drug

program would increase costs per enrollee, it would most

likely reduce the total cost of the drug benefit, because the

number of participants would be so much smaller. Such a

situation could become unstable, however, with premiums continuing to grow and enrollment continuing to

drop.

A number of strategies exist to offset the effects of adverse

selection into the drug program by encouraging many

people to participate. First, and perhaps most effective,

would be requiring one-time enrollment. A “choose it or

lose it” policy would foster high participation because

even healthy Medicare beneficiaries might be concerned

enough about developing an expensive medical condition

later on that they would take advantage of a one-time

opportunity to enroll. Participation might be further

increased by making enrollment in the program automatic unless the beneficiary took action to reject drug

coverage.

A second way to limit adverse selection would be to provide substantial government subsidies for the drug benefit. Because people are generally averse to risk, they are

willing to buy insurance even if the premiums they pay

exceed the value of the claims they expect to file over the

length of the policy. (People who are more risk averse

than the norm will be willing to pay even more in premiums for a policy with a given expected payout.) A government subsidy would increase the likelihood that a

person would receive insurance benefits in excess of his or

her premiums, so that person would be more likely to

sign up for a policy. Thus, if the government paid, say, 30

percent of an enrollee’s premium for drug coverage, even

relatively healthy Medicare beneficiaries might find it

advantageous to join a pool of less-healthy enrollees if

their premium reflected only 70 percent of such costs.

And, of course, the greater the number of healthy enrollees who joined, the lower that premium would become.

A third way to address adverse selection is by adjusting

premiums for individuals’ differences in expected risk (a

practice known as risk rating, which is used in many types

of insurance).6

 If healthy enrollees were charged a lower

premium that reflected their expected cost to the drug

program, they would be more likely to join. However,

adjusting the premiums that enrollees pay according to

their risk of high spending has not been part of Medicare

policy or of any recent proposal for a Medicare drug benefit.7

Some observers would argue that it would be unfair to

charge higher premiums to enrollees whose drug costs

were expected to be high because of preexisting medical

conditions.8

 Also, some people might argue that Medicare

is a form of social insurance that is intended to insure

against changes in health status that occur before people

reach the eligibility age for Medicare. In that view, everyone joining Medicare when they first become eligible

should face the same premium, regardless of their health

6. In this study, “risk rating” generally refers to charging people different premiums on the basis of differences in their expected costs.

Such differential premiums could be determined when people first

enrolled in a plan, on the basis of their health status and history, or

could result from periodic adjustments to their premiums based on

their claims experience (a practice known as “experience rating”).

Those two approaches are not mutually exclusive.

7. Medicare does charge higher premiums to people who decline

enrollment in Part B and later decide to join. That policy is intended to strongly discourage people from enrolling only when

they are about to face a large medical bill. By contrast, the riskrated premiums described above are not surcharges for late enrollment but rather differential premiums that would be charged to

enrollees when they were first eligible to join, with limited adjustments over time. 

8. Other observers have pointed out the inherent subjectivity in fairness arguments. Mark Pauly asks whether it is reasonable for a

relatively healthy lower-middle-income person to subsidize a sickly

rich person, which is an implication of charging all enrollees the

same premium. Pauly suggests that other ways may exist to subsidize sickly people besides requiring uniform premiums. See Mark

V. Pauly, “Is Cream-Skimming a Problem for the Competitive

Medical Market?” Journal of Health Economics, vol. 3, no. 1

(March 1984), pp. 87-95.
20 ISSUES IN DESIGNING A PRESCRIPTION DRUG BENEFIT FOR MEDICARE

status.9 Also, if Medicare policy allowed people’s premiums to vary over time as their health condition or claims

costs changed, enrollees would be denied the benefit of

being insured against such changes—a benefit that exists

when a plan must charge the same premium to everyone.

However, enrollees would still be insured against unexpected needs for prescription drugs that arose during the

period over which the premium was fixed.

A fourth way to reduce adverse selection would be to

make the drug program a mandatory part of Medicare

Part B. If drug coverage was incorporated into the

broader range of Medicare health benefits, even people

who expected to have low drug costs would be inclined to

enroll in order to insure against the general medical costs

they might face.

Adverse Selection Among Drug Plans

Proposals for a prescription drug benefit that call for

competing plans, each facing insurance risk for the claims

they pay, can result in interplan adverse selection.10 That

type of adverse selection occurs when beneficiaries with

high expected drug costs enroll in certain plans (and

avoid others) because they find the design of the coverage

or the services offered by certain plans to be particularly

appealing (or because the behavior of some insurers discourages them from enrolling in other plans). Interplan

adverse selection is likely to exist in two main instances:

when plans cannot easily identify potential enrollees with

low expected drug costs versus those with high expected

costs; and when, even if they can make that identification,

plans are not allowed (or find it costly) to charge different

premiums to enrollees on the basis of different expected

costs.

Recent proposals that envision multiple at-risk plans

competing for enrollees in the same market would require

each plan to charge all of its enrollees in that market the

same premium, thus making the problems associated with

interplan adverse selection more likely. Requiring a plan

to charge a uniform premium (often called community

rating) may be justified on the grounds that the purpose

of health plans is to insure people against medical problems over long periods of time (perhaps even against

problems that occurred before they were covered by a

plan). The alternative practice, allowing adjustments to

premiums through risk rating, may be impractical and

would reduce the value of insurance protection.11

The potential for interplan adverse selection would be

even greater if the government set a single premium for

all of the at-risk plans in a region instead of allowing each

plan to set its own premium (even if it had to charge that

premium to all of its enrollees). In the latter case, a plan

that appealed disproportionately to enrollees with higher

expected costs could charge a bigger premium to make up

for those costs. For their part, higher-cost enrollees might

be willing to pay that premium if they found the services

or coverage of the plan sufficiently more attractive than

those of alternative plans. If, instead, the government set a

single premium for all plans, that safety valve for plans

would not be available. As a result, plans would be more

likely to engage in behavior aimed at avoiding adverse

selection (by encouraging favorable selection), unless the

government took steps to prevent it.12

How Competing Plans Respond to the Risk of Adverse

Selection. When adverse selection appears likely, insurers

have various ways to avoid enrolling people who are apt

9. In some cases, one person may have a history of higher medical

costs than another person not because of poorer health but because

of a greater inclination to seek medical care. It may be reasonable

to charge a higher premium to someone who has shown a greater

willingness to use medical treatment for a given health status. In

practical terms, however, it would be difficult to separate medical

spending that reflected differences in health status from spending

that reflected a greater tendency to seek treatment.

10. More generally, the difficulties associated with interplan adverse

selection can arise if those plans have a financial stake in keeping

per capita claims costs down. That could happen under proposals

in which plans did not assume a pure insurance role. For example,

if a plan’s administrative fee would be reduced or forfeited when

the plan exceeded some performance standard that was highly correlated with per capita claims costs, the issue of interplan adverse

selection would be a problem.

11. Administrative costs would probably limit risk rating even if plans

were legally permitted to charge differential premiums. In that

case, plans might develop a limited number of rates tied to previous claims or specific health conditions.

12. Favorable selection is disproportionate enrollment by people with

low expected costs.
CHAPTER THREE PROBLEMS IN DESIGNING A MEDICARE DRUG BENEFIT 21

to prove unprofitable. One obvious strategy is for plans to

aim their marketing at subgroups of the elderly whom

they expect to be relatively healthy. Marketing a plan aggressively at golf clubs but not at nursing homes, for example, might reach low-cost enrollees while avoiding

high-cost ones.

Medicare drug plans would probably also design their

benefit packages in ways that would appeal to relatively

healthy enrollees rather than people with high expected

costs. They might cap benefits at levels below those likely

to be reached by seniors who have chronic conditions that

are associated with high drug costs, or they might require

substantial cost sharing. They could also use restrictive

formularies to tailor their plan’s appeal to people who

expect to have low drug costs.

In the competition for enrollees with low expected costs,

plans might end up offering similar insurance policies

and, to discourage high-cost enrollees, might offer the

minimum benefit permitted. But even having similar

policies would not completely erase the risk of adverse

selection or discourage plans from trying to achieve favorable selection, because plans could adopt many different

approaches to vary the quantity, quality, and price of the

services they offered. Thus, each plan would remain uncertain about the impact of its own and its rivals’ approaches on the pool of enrollees it would attract.

Because plans might try to avoid unprofitable enrollees by

offering sparse benefits, premiums could well be lower

than they would be without the risk of interplan adverse

selection. Nevertheless, those premiums would probably

still be higher relative to the benefits offered than would

otherwise be the case. The reason is that plans might

respond to the uncertainty of adverse selection by charging higher premiums, which they could use to accumulate

reserve assets to cover unexpectedly high claims. In general, plans’ fears of adverse selection are likely to be greatest in the early years of a Medicare drug benefit, as plans

learn how enrollees respond to their options and what

packages their competitors are offering. 

Another result of adverse selection among plans could be

an unstable insurance market, in which plans that initially

achieved favorable selection would have lower costs and

premiums than plans that experienced adverse selection,

causing enrollees to migrate from higher-cost to lowercost plans.

Ways to Prevent Interplan Adverse Selection. The government could employ various policy tools to mitigate the

negative effects of interplan adverse selection: standardizing plans’ benefits, standardizing their marketing, or

compensating plans for their differential costs through reinsurance or risk adjustment. In addition, as noted above,

the government could allow drug plans to charge riskrated premiums. However, mechanisms that would reduce adverse selection might create other problems.

Standardized Benefits. One strategy would be to require

all competing plans to offer certain features. Standardizing deductibles, cost sharing, benefit caps, and other aspects of coverage, for example, would keep plans from

using those features as agents of selection. But standardizing benefits might not prevent all selection-related behavior. Plans could use restrictive formularies and other management tools to deter enrollees with high expected costs

from choosing them. Virtually all recent legislative proposals have tried to prevent such behavior by requiring

plans that use formularies to offer at least one drug in

every therapeutic class. (Some proposals have required

that plans offer two or more drugs in each class.)

Standardizing benefits could introduce other drawbacks:

for instance, the benefit design that was written into regulations might not encourage cost-effective use of the various drugs that are available. Likewise, standardization

could stifle innovations in benefit design that might bring

about more cost-effective use of prescription drugs. Also,

consumers would lose the opportunity to find a plan tailored to their preferences for financial risk or their willingness to face a limited choice of drugs or pharmacies in

exchange for lower premiums.

Standardized Marketing. Another possible means to reduce adverse selection is to standardize the ways in which

competing entities market their drug plans. Requiring all

plans to use similar marketing materials and to have the

same procedure for enrolling beneficiaries could prevent

plans from targeting their marketing efforts toward consumers who are expected to have lower costs. However,
22 ISSUES IN DESIGNING A PRESCRIPTION DRUG BENEFIT FOR MEDICARE

standardized marketing materials could also make differences in coverage more apparent, which (in the absence of

standardized benefits) might give plans more incentive to

avoid designs that were likely to appeal to enrollees with

high expected costs.

Reinsurance. Another way to counter adverse selection is

for the government to provide reinsurance to participating plans. (Reinsurance involves a second insurer—in this

case, the federal government—assuming some or all of

the first insurer’s risk.) Under one type of reinsurance

mechanism, a drug plan would receive government funds

on the basis of the level of claims incurred by each of its

enrollees. If an enrollee’s claims in a year reached a specific level, the government would pay the plan a certain

fraction of the enrollee’s additional claims costs. That

fraction would increase as the enrollee’s claims grew. A

schedule of rising marginal reinsurance payments to plans

would reduce incentives for selection because plans would

receive higher subsidy rates for enrollees who incurred

greater drug costs.

Reinsurance payments could also be based on a plan’s

average claims cost for all enrollees. Only those plans

whose average cost exceeded some threshold amount

would receive reinsurance payments to cover part or all of

that cost. Neither kind of reinsurance would eliminate the

possibility of adverse selection, but they would cushion its

financial effects on plans and therefore reduce its costs.

Because reinsurance would be retrospective (based on incurred claims), however, it would have an important disadvantage: it would weaken incentives for drug plans to

control spending. A plan that controlled costs more effectively would receive a lower proportional federal subsidy

because its enrollees would be less likely to reach the

spending thresholds that trigger reinsurance subsidies. As

a result, reinsurance might reward inefficiency by covering a portion of plans’ high costs no matter what the

cause.

Risk-Adjustment Mechanisms. The government could also

avoid interplan adverse selection by using risk-adjustment

mechanisms. Under such a mechanism, the government

would pay additional money to plans that enrolled a disproportionate number of people with medical conditions

or other characteristics (such as age) associated with

higher drug costs. Ideally, such a mechanism would offer

additional payments that were large enough to neutralize

plans’ incentives to avoid enrollees who were expected to

have high drug costs.

Unlike reinsurance, a risk-adjustment mechanism would

be prospective rather than retrospective. In other words, it

would base the government’s payments to plans on likely

claims rather than actual claims. Ideally, those payments

would be determined in part by measures of an enrollee’s

health status that were considered good predictors of

future drug costs. However, developing an effective riskadjustment mechanism is still a work in progress. (For

more details, see Box 1.)

Risk Rating. A system that allowed plans to charge different premiums according to each enrollee’s experience

with, or likelihood of, claims could also reduce plans’

incentives to avoid high-cost enrollees. However, as noted

above, such risk-rated premiums dilute the degree to

which an insurance plan protects enrollees from uncertainty about their financial liability over the long run.

Policymakers might want to devise a subsidy scheme to

cushion the effects of higher premiums on enrollees who

were categorized as having high expected costs. A riskadjusted premium subsidy by the government would be a

way of implementing experience rating without demanding higher premiums from enrollees.

If potential enrollees can judge their expected claims

better than health plans can, even risk rating of premiums

may not be enough to eliminate adverse-selection behavior. The reason is that plans might not be able to determine the premium differentials they would need to

charge to protect themselves against attracting enrollees

who turned out to be more costly than expected.

Cost Containment

With Medicare beneficiaries expected to use nearly $87

billion of outpatient prescription drugs this year—and

that amount projected to grow by about 12 percent per

year—adding subsidized drug coverage to Medicare

would represent a major financial commitment for the
CHAPTER THREE PROBLEMS IN DESIGNING A MEDICARE DRUG BENEFIT 23

%R[ 

The Feasibility of Risk Adjusting the Drug Benefit in Competitive Plans

Risk adjustment is a method for varying payments to a

health plan according to the expected variation in health care

costs among the plan’s beneficiaries. (In the case of a Medicare drug benefit, those payments would come from the

federal government.) Payment rates are set on the basis of a

beneficiary’s risk status before each enrollment period begins.

Risk adjustment reduces the incentive that plans have to

avoid enrolling people who are likely to incur high health

care costs.

Risk adjustment is used in some private-sector health insurance plans and in Medicare’s payments to Medicare+Choice

plans.1

 However, a proven risk-adjustment mechanism does

not yet exist for prescription drugs, although researchers are

working to create one. For such a mechanism to be successful, it would have to be able to predict an enrollee’s future

drug costs with a high degree of accuracy. Moreover, it

would need to use predictors whose values could not be

changed by the actions of a health plan. For example, if a

risk-adjustment method relied on a person’s past use of

health services to predict future use, plans would have less

incentive to control their enrollees’ drug spending.

Most risk-adjustment methods available today (for predicting the use of health services other than drugs) depend on

data about a person’s previous use of services.2

 Even then, the

1. For a review of risk-adjustment methods, see Robert Wood

Johnson Foundation, Changes in Health Care Financing and

Organization Program, Risk Adjustment: A Key to Changing

Incentives in the Health Insurance Market (Washington, D.C.:

Alpha Center, March 1997), available at http://hcfo.net/pdf/

riskreport.pdf.

2. The risk-adjustment method in place for Medicare+Choice

plans during the 2000-2003 period is called the principal inpatient diagnostic cost group method. That method identifies

high-cost beneficiaries for a year on the basis of the principal

inpatient diagnosis assigned to them during an inpatient hospital

stay the previous year. The statistical relationship between that

diagnosis and total spending on Medicare services the following

year is used to calculate a risk score for the beneficiary. Thus, an

assignment of elevated risk depends on a patient’s entering a

hospital. In 2004, the Medicare+Choice program will move to

a risk-adjustment method that uses data from outpatient hospital and physician visits as well as from inpatient hospital stays.

available methods predict only a small part of the variation

in different people’s use of services.3

It might be possible to develop a more accurate risk-adjustment method for prescription drugs than for other health

services (especially hospital care), because people’s drug

spending is more stable from year to year. In addition, there

would not be the long lag in data collection that exists for

other Medicare claims; data on drug utilization would be

available more quickly through the electronic claims technology developed by pharmacy benefit managers. Still, by giving

plans that did less to manage drug utilization a higher risk

score for their enrollees, a risk-adjustment method based on

use could undermine incentives for cost control.

Integrating risk adjustment into the design of a Medicare

drug benefit would require finding a way to make additional

payments to plans for high-cost enrollees on a prospective

basis. One approach would be to adjust the government’s

share of the plan’s premium, similar to the approach now

used in the Medicare+Choice program. Another method

would be to provide “risk” subsidies using an administrative

mechanism similar to the one that would be used to provide

low-income subsidies to drug plans.

Another issue is how additional risk-adjustment payments

would be counted in reaching reinsurance thresholds (in

proposals that call for reinsurance). Thresholds could be

raised to take such payments into account. The thresholds

could be different for different diagnoses or could be applied

to a plan’s total costs rather than to costs for individuals. As

risk adjustment was refined over time, reinsurance payments

could be phased out.

That method will continue to assign risk scores that are based on

the relationship between a diagnosis and total spending on Medicare services the following year.

3. For a recent comparison of methods for assigning health risks,

see Robert B. Cumming and others, A Comparative Analysis of

Claims-Based Methods of Health Risk Assessment for Commercial

Populations (Schaumburg, Ill.: Society of Actuaries, May 2002),

available at www.soa.org/sections/riskadjfinal/report1.pdf.
24 ISSUES IN DESIGNING A PRESCRIPTION DRUG BENEFIT FOR MEDICARE

federal government. Indeed, the four proposals discussed

in Chapter 4 would cost the government between $195

billion and $512 billion during their first eight years, the

Congressional Budget Office estimates. Moreover, Medicare spending is expected to soar over the next three decades as the baby-boom generation becomes eligible for

the program.

For all of those reasons, controlling costs is a key problem

in designing a Medicare drug benefit. The size of that

problem depends on the extent of the benefits offered

under the drug program.

As noted earlier, the level of coverage that is provided is

the most important determinant of the overall cost of the

benefit. The main reason is that more-generous coverage

shifts more of the burden of paying for drugs from the

consumer to the drug plan. Another reason is that by

lowering the effective price that people must pay for a

prescription, new or better drug coverage encourages enrollees to use more, or more costly, drugs than they would

otherwise. The more extensive the coverage (the lower the

deductible, the required cost sharing, and the catastrophic

stop-loss limit), the greater the stimulus to demand for

prescription drugs—and the greater the burden on cost

management to restrict that growth in demand.

The effect of the Medicare benefit on drug spending

would depend not only on the structure of the benefit but

also on the drug coverage that enrollees receive now—and

might continue to receive—from other sources. For the

one-quarter of Medicare beneficiaries without drug coverage, demand for prescription drugs would surely rise

when they enrolled in the program because they would be

paying less for at least some of their drugs. The size of

that increase in demand would depend directly on the

structure of the benefit.

For the three-quarters of beneficiaries who already have

some public or private drug coverage, the effect on their

use of prescription drugs would be more complicated.

Their demand would increase only if Medicare’s benefit

was more comprehensive than, or was supplemented by,

the coverage they now have. If the Medicare benefit was

less comprehensive than their current coverage, their

demand for drugs could decline, but only if the Medicare

benefit completely replaced all other coverage. (For more

details of how different kinds of supplemental coverage

would interact with a Medicare drug benefit, see Box 2).

Active management of the Medicare drug benefit could

encourage the use of fewer or less-costly drugs. Most recent proposals assume that the benefit would be administered by entities that have the capabilities of pharmacy

benefit managers, which most employment-based health

plans use to administer and manage their prescription

drug benefits. In recent years, private-sector health plans

have increasingly refined their cost-sharing rules so that

enrollees are encouraged to buy less-expensive drugs and

to fill prescriptions through pharmacies in their network

or through mail-order facilities (when that form of dispensing is more efficient).

The degree to which PBMs or other entities could effectively control Medicare drug costs would depend on their

having both the authority and the incentive to aggressively use the various tools at their disposal. Key among

those cost-management tools are formularies and related

approaches to steer demand for drugs to preferred products. (For a description of some of those approaches used

in the private sector, see Appendix A.)

In addition, requiring benefit managers to assume some

insurance risk for the benefits they pay out and allowing

multiple entities to compete for enrollees on the basis of

premiums and reimbursements would give managers

greater incentive to use the tools they have at hand to

hold down spending (although both of those approaches

would entail some costs). Even the most effective benefit

management, however, would not keep the prices of some

drugs from rising under a Medicare drug program.

Cost-Management Tools 

In general, a trade-off exists between enrollees’ ability to

easily obtain the drugs of their choice and a plan’s effectiveness at managing drug spending. Aggressive use of

formularies, preferred-drug systems, generic-pricing systems, pharmacy networks, mail-order pharmacies (when

they are less costly), disease management, and physician

and patient education can alter the number and kinds of

drugs used and lower the price at which they are acquired

from manufacturers and pharmacies. All of those tools, to
CHAPTER THREE PROBLEMS IN DESIGNING A MEDICARE DRUG BENEFIT 25

%R[ 

How a Medicare Drug Benefit Would Interact with Supplemental Drug Coverage

Roughly three out of four Medicare beneficiaries have drug

coverage through such sources as employment-based health

plans for retirees, state programs (including Medicaid), and

individually purchased medigap policies. How those supplemental sources of coverage would operate after the introduction of a Medicare drug program would determine the extent

to which the Medicare benefit stimulated demand for prescription drugs. It would also affect the ability of the benefit’s administrators to use cost-management tools effectively.

Effect on People with Employment-Based Plans

Some beneficiaries who already have drug coverage through

their employer could lose that coverage if a Medicare drug

program was created. In recent years, employers have reduced the share of premiums they pay for retirees and, in

some cases, have eliminated health benefits for retirees entirely. That trend could accelerate if a drug benefit was

added to Medicare.

Employment-based drug coverage is typically more generous

than the coverage envisioned under most of the recent proposals for Medicare. Thus, people who lost employmentbased coverage might have an incentive to spend less on

drugs under Medicare than they do now, because they would

be paying more of the costs themselves.

Employers who kept a drug benefit for retirees would most

likely provide it as a supplement to Medicare’s coverage, as

they already do for coverage of physician and hospital care.

They would require beneficiaries to enroll in the Medicare

drug program to retain their private coverage. The employment-based plan would probably reimburse beneficiaries for

any difference between what it would have covered and what

Medicare would cover. (For example, a plan that had no

deductible might pay for beneficiaries’ drug purchases below

the deductible amount in Medicare.) Enrollees who continued to have access to generous supplemental coverage would

have limited incentive to curb their drug spending under

Medicare, regardless of the design of the benefit.

Effect on People in State Programs 

Beneficiaries eligible for Medicaid or state-run pharmaceutical assistance programs would also have little reason to alter

their spending on drugs. State Medicaid agencies would

most likely enroll beneficiaries with dual eligibility in the

Medicare drug program, since doing so would reduce the

agencies’ costs. (Those costs would decline because the premium for the Medicare drug benefit, which would be based

on the average cost of all participants in the benefit, would

probably be lower than the average cost of drugs for dual

eligibles. If the federal government subsidized any of Medicare’s drug premium, state Medicaid costs would decrease

even more.) Like retiree health plans, Medicaid would supplement Medicare’s drug coverage.

The Congressional Budget Office expects that state-based

pharmaceutical assistance programs for low-income seniors

would quickly be refocused once a Medicare drug benefit

was in place. If the new Medicare benefit did not include

premium and cost-sharing assistance for the programs’ target

groups, those programs might be redesigned to “wrap

around” (supplement) Medicare, just as Medicaid would.

Thus, a Medicare drug benefit would probably have little

impact on those beneficiaries’ demand for drugs, and the

wraparound coverage could undermine any incentive to control costs that was built into the structure of the Medicare

drug benefit.

Effect on People with Individual Drug Coverage 

Only a small percentage of Medicare beneficiaries have private medigap policies that include drug insurance. As noted

in Chapter 1, the drug coverage provided by those policies is

expensive and limited, with annual benefits capped at either

$1,250 or $3,000. Since medigap premiums are not subsidized and the plans have higher administrative costs than a

Medicare plan probably would, medigap enrollees could get

drug coverage through Medicare at lower cost. Thus, medigap plans with drug coverage as now structured would probably disappear, and new medigap plans (if allowed) would be

developed to wrap around the Medicare drug benefit. Those

wraparound provisions would stimulate demand for drugs

and weaken the ability of Medicare to control costs. Conversely, prohibiting new medigap plans from offering drug

coverage would help keep demand from rising.
26 ISSUES IN DESIGNING A PRESCRIPTION DRUG BENEFIT FOR MEDICARE

one degree or another, work by influencing physicians’ or

consumers’ choices about what drug to prescribe or where

to fill a prescription.

Proposals that limit the scope of cost-management tools

available to benefit managers would reduce the potential

for controlling costs and demand. As an example of such

limits, some recent proposals would require benefit managers to reimburse enrollees for a nonformulary drug if

the prescribing physician certified that the drug was medically necessary. Other proposals would require that formularies include at least two drugs in each therapeutic

class. Still others would limit the ability of benefit managers to exclude pharmacies from their network contracts.

Having a single PBM administer the Medicare drug benefit in each region, as some proposals envision, could pose

problems for the use of formularies. If each PBM established its own formulary, enrollees in the Medicare drug

program would have to pay different prices for the same

drug solely on the basis of where they live. Those differences might not prove acceptable politically. Conversely,

if Medicare adopted a nationwide formulary, that formulary would probably not be very restrictive, because nationwide exclusion from the Medicare market could

threaten the profitability—and even the survival—of

some drug manufacturers. (If the regions were large

enough, exclusion of a drug from the formulary of even

one region would also have significant financial implications for some manufacturers and might be difficult to

sustain politically.)

Compromise approaches—such as limiting reimbursements for nonpreferred drugs only to the amount that

would be paid for a therapeutically equivalent preferred

drug—would probably make systems that steer patients

toward certain drugs more acceptable under a single-PBM

design. Such approaches could also save money if the

cost-sharing requirements adopted under a proposal were

flexible enough (see Appendix A).

An important limit on the ability of any benefit manager

to control the costs of a Medicare drug benefit is the fact

that some enrollees might continue to have extensive drug

coverage through public programs or private health plans

(see Box 2). If a supplemental insurer paid the bulk of an

enrollee’s drug copayment regardless of whether the drug

was on the PBM’s formulary or preferred-drug list, the

usefulness of formularies and similar cost containment

methods would diminish. The leverage that PBMs might

have with pharmacies or manufacturers would be weakened as a result.

Insurance Risk and Competition 

The incentive to control spending would be strong if the

administering entity bore substantial insurance risk for

delivering the benefit at or near some target cost. That

situation would arise if the entity had to pay part or all of

the extra cost when per-enrollee spending exceeded the

target—and, conversely, got to keep at least part of the

savings when that spending was less than the target. The

incentive to curb costs would be even greater if the entities administering drug plans also had to compete with

each other for enrollees on the basis of premiums and

out-of-pocket drug costs. All other things being equal,

enrollees would reward lower-cost plans with their business.

Although insurance risk and competition would encourage cost containment, they would also give plans more

incentive to use management tools to achieve favorable

selection than would be the case if a single plan was

awarded a contract for all enrollees in a region. All plans

would probably adopt similar tools as a defense against

the use of such tactics by their competitors. However,

there may be natural limits to the use of aggressive management tools by competing plans, because enrollees

would choose among plans not only on the basis of premiums and costs but also on the basis of quality and service.

Some policymakers question the importance of competition and the assumption of insurance risk as ways to save

money from managing a drug benefit. In the private sector, PBMs typically do not assume any insurance risk for

the drug benefits they administer, but they are often given

broad authority to use an array of management tools on

behalf of a plan. They may also be subject to having a

bonus added to—or a penalty subtracted from—their

administrative fee according to how well they meet specific performance goals. A similar approach was envisioned in some of the recent proposals for a Medicare
CHAPTER THREE PROBLEMS IN DESIGNING A MEDICARE DRUG BENEFIT 27

drug benefit, which called for a single PBM selected periodically to serve each region, with all of the insurance risk

borne by Medicare.

Two important differences exist, however, between how

employment-based health plans and the government

might use a PBM to control costs. First, proposals for a

Medicare drug benefit generally include statutory limits

on the management tools that Medicare could require of

PBMs. Employment-based plans, by contrast, can more

easily change cost control strategies as circumstances dictate.

Second, and more important, the federal workers who

would make decisions for the Medicare drug program

face different incentives than private companies and their

decisionmakers do. Most private employers who offer

health coverage operate in a competitive marketplace,

which requires them to keep costs down so they can price

their products competitively while maintaining generous

enough benefits to attract skilled workers. Medicare faces

pressure to deliver promised benefits to enrollees; its incentives for cost containment are probably not as strong

as those of a private employer.

Medicare drug proposals that call for multiple risk-bearing plans to compete for enrollees’ business, with few

restrictions on cost control mechanisms, have the greatest

potential to constrain drug costs through management.

However, the savings in drug costs would be partly offset

by two kinds of additional costs: the cost of bearing insurance risk, and the marketing costs that competitive

plans would have to incur. In the end, the degree to

which those added expenses put a drag on cost management would depend on the details of the benefit design.

The Insurance-Risk Premium. A modest cost increase

will occur whenever a drug program requires a private

entity to bear insurance risk. In general, riskier enterprises

need higher dollar returns to operate than less-risky ones

do, because unless investors are compensated for bearing

the extra risk, investment in those enterprises will dry

up.13 All private firms face risk in the normal course of

doing business (such as the risk of misjudging labor costs

or the strength of competition). Those normal business

risks are not likely to differ among proposals for a Medicare drug benefit. But a design that requires PBMs or

other entities administering the benefit to bear insurance

risk imposes a higher cost on such entities than does a design that leaves insurance risk in the hands of the government. That additional cost is referred to as the insurancerisk premium.

One source of insurance risk is uncertainty about such

things as the increase in demand that would arise from

better drug coverage or unexpected scientific advances

that could boost drug spending. Another source of insurance risk is the possibility of adverse selection. If there

was a single Medicare drug plan in each region, and if a

large share of the eligible Medicare population enrolled in

the drug program, that source of risk would be minimal.

With multiple plans, however, the risk of adverse selection becomes a significant concern. As noted earlier, that

concern would be greatest in the early years of the program, when plans would have little data from which to

predict their enrollees’ drug spending or the benefits offered by their competitors.

Assessing the size of the insurance-risk premium is difficult. On the one hand, growth in the use of new drugs

can be hard to predict, and the possibility of ending up

with enrollees who have above-average costs is worrisome.

On the other hand, traditional financial theory suggests

that the premium should be small or even zero. The reason is that new Medicare drug plans would most likely

become additional holdings in the diversified portfolios of

large investors. Those diversified portfolios would be

subject to financial risks for the economy as a whole but

would be protected from the idiosyncratic risk of any particular investment. From the point of view of an investor

holding such a portfolio, the firm-specific risks of Medicare drug plans would balance out the risks associated

13. One possible response to risk is to take actions to reduce it. For

example, companies might take out insurance against uncertainties

in the market, or they might accumulate cash reserves to deal with

contingencies. Such actions would directly increase the costs of

doing business, which would mean higher prices, whereas a firm

that declined those approaches would have to deliver higher returns to investors, which would also mean higher prices.
28 ISSUES IN DESIGNING A PRESCRIPTION DRUG BENEFIT FOR MEDICARE

with other firms. Unless the insurance risks of the drug

plans were correlated with the general financial risks of

the economy, the risk premium for drug plans would be

small.

In practice, however, insurance risk would probably give

rise to real costs, which would be reflected in the premiums charged by competing plans. For instance, in an

effort to avoid losses, managers might buy reinsurance,

which is generally priced above its expected payouts in

order to cover the reinsurers’ own selection risks as well as

their business costs. Managers might also try to accumulate reserves to cover possible losses. Although those reserves could be invested in interest-bearing assets, holding

them would still entail costs.

In short, the risk premium would be an economic cost of

any drug benefit that required a private entity to bear

insurance risk. Uncertainty about trends in demand or

technology would impose a cost on the entity that would

require compensation. The risk premium would be

higher for designs that envisioned competitive plans than

for one in which a single plan bore insurance risk. Of

course, the alternative—having the federal government

bear insurance risk—would increase the government’s

uncertainty about its spending in any enrollment period

and thus make budgeting for the Medicare drug program

more difficult.

Plans’ Marketing Costs. Competition would introduce

additional expenses associated with marketing to and enrolling Medicare beneficiaries, which would not arise if a

single plan administered the drug benefit in each area. In

a competitive system, the government would inform beneficiaries that Medicare drug coverage was available to

them. The competing plans would then have to provide

specific information about their plans to beneficiaries. If

plans were also responsible for enrolling beneficiaries and

collecting their premiums, the cost of carrying out those

administrative functions would be higher than under a

single-plan system. Most single-plan designs would probably adopt the relatively seamless administrative process

used for Part B of Medicare, in which beneficiaries are

automatically enrolled unless they decline coverage, and

uniform premium amounts are deducted from beneficiaries’ monthly Social Security checks.

The extra administrative costs associated with competition could be reduced if plans were responsible for marketing but the government administered the enrollment

and premium-collection processes. A uniform process

would benefit from economies of scale. Moreover, the

infrastructure for determining eligibility, enrolling people, and collecting premiums already exists in the Medicare program.

Effects on Drug Prices 

Even with active cost management by plans, prices for

some prescription drugs would rise as a result of a Medicare drug benefit. As noted above, insurance stimulates

demand for covered drugs by reducing their cost to beneficiaries. If the pharmaceutical industry were perfectly

competitive, manufacturers would probably respond to

higher demand not by raising prices but by increasing

production at little additional cost, at least in the long

run. (Short-run shortages of supply might lead to higher

prices, but competition would ensure that drug companies would invest in new production capacity to meet the

higher demand.)

The pharmaceutical industry is far from perfectly competitive, however. Drugs are unique among health care products and services in that many are subject to unusually

strong intellectual property rights, which protect their

manufacturers from competition. Those rights stem not

only from patents but also from the exclusive rights to sell

drugs that the Food, Drug, and Cosmetics Act grants to

drugmakers in certain situations. The Food and Drug

Administration, whose primary responsibility is to ensure

the safety and efficacy of drugs sold in the United States,

also helps enforce those intellectual property protections.

As long as a drug is protected from imitation by patent or

other exclusive marketing rights, its manufacturer has a

legal and well-enforced monopoly over the product.

In the case of many drugs, companies’ monopoly power is

limited because close substitutes for the drug are available.

For example, among the widely used cholesterol-lowering

agents known as statins, five different chemical entities,

each protected by patents, have similar modes of action

and effectiveness.14 As a result, companies that sell those

14. Institute of Medicine, Description and Analysis of the VA National

Formulary (Washington, D.C.: National Academy Press, 2000).
CHAPTER THREE PROBLEMS IN DESIGNING A MEDICARE DRUG BENEFIT 29

drugs often spend considerable sums to advertise and promote their products and must consider the competition

in setting prices.

Occasionally, though, a specific drug offers unique clinical benefits of such magnitude that the only limit on its

price is consumers’ willingness or ability to pay.15 Insurance effectively increases consumers’ willingness or ability

to pay for covered drugs, so a generous drug benefit—

with low cost-sharing requirements, high benefit caps, or

low catastrophic stop-loss limits—would make newly insured patients more tolerant of high prices. If a unique

drug with major clinical benefits had a target population

composed mainly of Medicare beneficiaries, a new benefit

with a low catastrophic stop-loss limit could cause the

drug’s manufacturer to raise the current price or enter the

market with a high launch price. (Medicare would have

few ways to prevent very high prices for such drugs, apart

from imposing direct price controls or threatening to

deny or delay coverage. However, the threat of such constraints could increase uncertainty about the market for

new drugs and thus discourage investment in pharmaceutical research and development.)16

Such exceptional cases aside, the most likely effect of a

Medicare drug benefit would be only moderate price

increases, and only for drugs with patent protection or

exclusive marketing rights. One reason is that Medicare

beneficiaries make up just part of the prescription drug

market. A manufacturer who wanted to raise prices would

have to weigh the higher revenue available from newly

covered Medicare beneficiaries against the potential for

lost market share among other buyers. A second reason is

that since many Medicare patients have good drug coverage now, the effect on drug prices of even the most generous Medicare benefit would be diluted (because drug coverage is already reflected in current or expected prices).

Nevertheless, the potential for manufacturers of patentprotected drugs to raise prices underscores the importance

of giving the entities charged with managing the benefit

both the incentive and the authority to use cost-management tools. If PBMs or health plans could actively manage drug utilization through formularies or other strategies, they could closely scrutinize drugmakers’ claims of

clinical superiority. And by exploiting opportunities for

price competition, they could hold pricing power in

check when close substitutes existed.17 Conversely, if

PBMs or health plans were discouraged from actively

managing the Medicare drug benefit in those ways, there

would be fewer limits on price increases.

Administrative Feasibility

Most recent proposals for a stand-alone Medicare drug

benefit envision having private entities administer the

benefit, but they differ markedly in the functions that

such entities would perform. Some proposals would require those administrators not only to play the roles that

PBMs do in the private sector but also to compete for enrollees, bear insurance risk, and cope with federal (and

possibly state) regulation of their activities. The willingness and ability of private entities to participate under

those conditions would affect the speed with which a

Medicare drug program could be implemented nationwide and its ultimate cost.

Plans’ Participation in a Single-Plan, No-Risk Design

In a design (such as the Clinton Administration’s plan)

that envisions a single administrative entity for each part

of the country, with the government bearing insurance

risk, entities such as PBMs would compete for contracts

to manage the drug benefit for everyone who enrolled in

an area. The government would presumably issue a request for proposals for each region and award a contract

to a single entity in that region using a bidding process.

The bidding would determine how much the government 15. One drug with unique clinical benefits is alglucerase, which replaces an enzyme that is deficient in people who have Gaucher disease, a frequently disabling and sometimes fatal condition if not

treated. A single company currently has the exclusive right to market alglucerase. For a description of the disease and therapies, see

the Web site of Genzyme Therapeutics (www.genzyme

therapeutics.com/cerezyme).

16. See Congressional Budget Office, How Health Care Reform Affects

Pharmaceutical Research and Development (June 1994).

17. Even the first drug in a new therapeutic class can soon face competition from similar drugs or therapies. The introduction of a new

class of pain relievers, known as Cox-2 inhibitors, is a case in

point. The first molecule in the class was approved for marketing

in the United States at the end of 1998. A second drug was approved only a few months later, in May 1999. Similar drugs are

currently awaiting approval for marketing in the United States.
30 ISSUES IN DESIGNING A PRESCRIPTION DRUG BENEFIT FOR MEDICARE

paid each entity for processing claims on a fee-for-service,

no-risk basis.

The administrative functions required in a single-plan,

no-risk design would be similar to the functions that

PBMs now perform for employment-based health plans.

Although certain features of that type of Medicare drug

program could discourage some PBMs from bidding for

contracts, it is likely that several large PBMs would be

willing to participate. With the chance to manage drug

claims for millions of Medicare beneficiaries at stake,

PBMs would have an incentive to bid for contracts from

the beginning, because the winning bidder in the initial

competition would be awarded an exclusive, potentially

multiyear contract and could thus have a competitive

advantage in future bidding.18 Managing the Medicare

benefit might also give PBMs an advantage in competing

for contracts with employment-based plans, because it

would simplify the coordination of benefits for retirees.

Larger PBMs, with the infrastructure to administer broad

pharmacy networks and negotiate with drugmakers for rebates, might have a competitive advantage over smaller

PBMs. Thus, administration of the Medicare drug benefit

might end up being concentrated among a few large

PBMs. Such concentration would not necessarily lead to

higher costs, since bigger PBMs might be able to achieve

economies of scale that smaller ones could not. But unless

enough potential bidders survived and the contracts were

rebid periodically, the approach of having a single regional benefit manager could eventually reduce incentives

for contractors to operate efficiently and for the government to continue to achieve savings through competitive

contracting. The ultimate impact on Medicare costs is

uncertain: it would depend largely on the dynamics of the

competitive-bidding process used to award contracts.

Plans’ Participation in a Competitive, Risk-Based Design

The question of participation is more complex in a design

in which multiple entities would be competing for enrollees in a region and those entities bore the insurance

risk. Adopting risk-based payment would require PBMs

to change their current business model to put more emphasis on cost control. (In the private sector, PBMs agree

contractually to meet certain performance targets, such as

specific price discounts and utilization rates, but they are

not at risk for total spending. Employers or insurance

companies have the responsibility for managing enrollment, bearing risks, and complying with state and federal

regulations that govern health plans.) The need for

greater emphasis on cost control under a risk-based approach would require some PBMs to restructure themselves and could delay or discourage their participation.

For example, to compete as risk-bearing entities, most

PBMs would probably need to develop partnerships with

insurance companies and seek state licenses. Alternatively,

PBMs could offer their traditional benefit-management

services to insurance companies that would provide the

Medicare drug coverage.

Another barrier to plans’ participation in a competitive

design would be uncertainty about adverse selection, particularly interplan adverse selection. Especially in the early

years of the program, plans might be unable to gauge how

much interplan-selection risk they would encounter or to

know how effective their strategies to counter such risk

would be. Managers might take a “wait and see” approach

to participation. Even if plans modified their design to

mitigate adverse selection, as described earlier, the number of competing plans might be fewer in the initial years.

Concerns About Regulatory Changes. Insurers have

stated that they would be reluctant to offer Medicare drug

plans out of concern that the federal government or state

governments might modify the rules of enrollment after

the fact.19 In particular, they worry that over time, the

Congress might allow exceptions to one-time enrollment

because of pressure from constituents, thus undercutting

the effectiveness of one-time enrollment in preventing

adverse selection. Insurers have also expressed concern

that state regulators might try to alter benefit packages or

set other requirements that would impose unworkable

limits on them.

18. See CBO’s estimate of the Clinton Administration’s prescription

drug proposal in Congressional Budget Office, CBO’s Analysis of

the Health Insurance Initiatives in the Mid-Session Review (July 18,

2000).

19. See the testimony of Charles N. Kahn III, President, Health Insurance Association of America, before the House Committee on

Ways and Means, June 13, 2000.
CHAPTER THREE PROBLEMS IN DESIGNING A MEDICARE DRUG BENEFIT 31

Actions by states to license and regulate drug plans could

have a significant impact on plans’ initial participation in

the Medicare drug program. State insurance regulators

might issue new rules for licensing such plans, including

standards for financial solvency, that could vary widely

from state to state. The time needed to obtain a license in

each state would also vary. In addition, the relative speed

with which states put requirements in place could affect

start-up costs for plans trying to obtain licenses in multiple states. Moreover, depending on the type of prescription drug benefit enacted, state insurance regulations

might affect the tools a plan could use to control drug

costs, the procedures for enrollees to appeal decisions

about coverage and to settle grievances, and the premiums

that Medicare beneficiaries would pay for drug coverage.

(For more information about current state laws that could

affect Medicare drug plans, see Box 3.)

One way to work within those laws and possibly encourage the formation of nationwide plans would be to enact

a federal preemption of state laws governing Medicare

drug plans.20 In addition, the federal administrator of the

Medicare drug program could be given power to grant

waivers of state insurance regulations. Waivers could be

granted if states failed to process license applications

quickly enough or if they imposed other barriers to licensing, such as requiring plans to meet more-stringent solvency standards than those established by federal regulation.

Participation by Medicare+Choice or Public Plans.

One type of plan would be likely to participate from the

beginning in a competitive, risk-based design: Medicare+

Choice plans. Those plans have the marketing, enrollment, and customer-service infrastructure to compete for

enrollees. They also have experience bearing insurance

risk and working within the regulatory structure of the

Medicare program. Providing drug coverage to Medicare

beneficiaries could be done seamlessly through M+C

plans as an enhancement of their basic benefits. In that

case, however, drug coverage would be available only to

beneficiaries who enrolled in M+C plans for their basic

Medicare benefits.

In some areas, it is possible that only one plan or even no

plans would participate in the drug program. Without

multiple plans in a region, the full benefits of competition

would not be realized. If that happened, the government

might have to provide its own public plan as a fallback in

those areas to ensure a competitive benefit nationwide or,

alternatively, provide additional financial incentives for

private plans to operate in those regions. Fallback plans

would be very vulnerable to interplan adverse selection in

any region in which there was also a stand-alone drug

plan or a Medicare+Choice plan. If the fallback plan was

less aggressive than other plans in managing costs, the

federal government could end up paying more, on average, in areas requiring such direct intervention.

Effects on Other Parts of Medicare

Adding a stand-alone prescription drug benefit to Medicare would have ripple effects on the rest of the program.

With greater access to prescription drugs, some Medicare

beneficiaries might use fewer health care services; in other

cases, though, use of health care could increase. (The evidence that exists from past studies is inconclusive.) In all,

costs for other Medicare services would probably not

change significantly.

A drug benefit would also affect enrollment in Medicare’s

managed care plans (Medicare+Choice) by diluting one of

their current competitive advantages—prescription drug

coverage. However, M+C plans might be more likely to

continue participating in Medicare because they would

receive payment for their drug coverage rather than having to finance it themselves.

Impact on Other Medicare Services

By reducing financial barriers to the purchase of prescription drugs, a Medicare drug benefit would free up income

for elderly people to use on other things, including additional health care. And by lowering the out-of-pocket

price of prescription drugs for some enrollees, the benefit

would stimulate demand for more, and possibly more

costly, prescription drugs than before. Greater access to

outpatient prescription drugs would improve the health

20. Alternatively, regulatory functions might be shared between the

federal and state governments. For example, states might issue insurance licenses, and the federal government would regulate rates

and benefits.
32 ISSUES IN DESIGNING A PRESCRIPTION DRUG BENEFIT FOR MEDICARE

%R[ 

State Insurance Laws That Affect Prescription Drug Plans

A Medicare drug program that failed to preempt state

insurance laws would subject participating plans to a

wide array of regulations. Those regulations would

make it more costly for plans to enter some markets,

which could hinder the development of regional drug

plans.

Many states have laws that would limit plans’ ability to

use certain tools—such as formularies and selective

contracting with pharmacists—to control drug costs.

As of December 2001, 26 states required health plans

to have procedures whereby an enrollee can request

coverage for drugs not on the plan’s formulary. Eight

states required plans, in certain cases, to continue covering drugs that are removed from the formulary.1

 In

addition, 17 states had “any willing pharmacy” laws,

which require managed care plans to contract with any

pharmacy that is willing to meet the terms and conditions of the contract, and 16 states had “freedom of

choice” laws, which prohibit plans from restricting enrollees’ choice of pharmacies in return for a price discount. (Nine states had both types of laws.)2

 Plans

administering the Medicare drug benefit in those states

would face higher costs, which could result in higher

premiums or cost-sharing amounts for enrollees.

Many states also regulate the procedures for enrollees in

managed care plans to appeal decisions about coverage

1. Blue Cross Blue Shield Association, State Legislative Health Care

and Insurance Issues: 2001 Survey of Plans (Washington, D.C.:

BCBSA, 2001).

2. Health Policy Tracking Service, 2001 State by State Guide to

Managed Care Law (Washington, D.C.: National Conference of

State Legislatures, 2001).

and to settle grievances. At the end of 2001, 41 states

and the District of Columbia had laws mandating the

establishment of an independent or external review process for consumers to appeal certain adverse judgments.3

 Laws in nine states allow an enrollee to hold a

health plan accountable for its treatment decisions and

to sue the plan in the appropriate civil court.4

Other state laws would affect the premiums that plans

could charge for Medicare drug coverage. Ten states

have enacted community-rating legislation, which requires health insurers to charge policyholders the same

premium regardless of their health status or history of

claims.5

 Twenty-nine states have laws that require plans

selling health insurance in some markets to obtain prior

approval of their rates from the state’s insurance commission.6

3. Henry J. Kaiser Family Foundation, Assessing State External Review Programs and the Effects of Pending Federal Patients’ Rights

Legislation (Menlo Park, Calif.: Kaiser Family Foundation,

2002).

4. Henry J. Kaiser Family Foundation, Key Characteristics of State

Managed Care Organization Liability Laws: Current Status and

Experience (Menlo Park, Calif.: Kaiser Family Foundation,

2001).

5. AARP Public Policy Institute, Reforming the Health Care System:

State Profiles 1998 (Washington, D.C.: AARP, 2000), and personal communication to the Congressional Budget Office by

staff members of AARP, January 17, 2001.

6. National Association of Insurance Commissioners, NAIC’s Compendium of State Laws on Insurance Topics (Kansas City, Mo.:

NAIC, 2000), and personal communication to the Congressional Budget Office by staff members of the National Association of Insurance Commissioners, January 17, 2001.
CHAPTER THREE PROBLEMS IN DESIGNING A MEDICARE DRUG BENEFIT 33

of some seniors, which could reduce their use of hospitals

and other services.

However, it is not clear that total costs for other Medicare

services would decline. For one thing, greater use of

drugs, especially in an older population, would increase

the chances of side effects, allergic reactions, medication

errors, and other adverse events—which could lead to

new or longer visits to hospitals, emergency rooms, and

other health care services.21 To try to limit the frequency

of adverse drug events for people on chronic therapies,

physicians often require periodic visits and lab tests, and

those precautions also raise costs.

A Medicare drug benefit could have a beneficial effect,

however, on certain kinds of adverse drug events—those

stemming from inappropriate dosing and interactions

between drugs. Under most proposals, the benefit would

be managed by entities that use electronic claims systems,

which can identify and warn patients or prescribing physicians of potentially dangerous interactions when drugs

are dispensed. That feature would be newly available not

only to enrollees who now lack drug coverage but also to

enrollees whose current coverage is not administered

through such systems.

The evidence that is available to gauge how access to drug

coverage affects health care costs is difficult to interpret.

Few research studies address the question directly; rather,

they examine the effects of a specific drug or class of

drugs on health costs. Only a handful of studies have

looked at the impact of drug coverage on health costs,

and they have focused only on the most vulnerable and

chronically ill subgroups of the population. Taken as a

whole, the evidence from those studies is inconclusive.

Some recent research suggests that using more and newer

drugs may reduce the use of other health care services; but

other studies suggest that modest increases in financial

access to drugs for elderly patients may not produce such

a reduction. (For a more-detailed review of the research

findings, see Appendix B.) New evidence may become

available in the next year as researchers complete evaluations of state pharmaceutical assistance programs for the

elderly.

Even if a drug benefit led to net savings in other Medicare

costs, those savings would probably be relatively small, for

two reasons. First, beneficiaries with Medicaid or employment-based insurance already have better coverage than

would be available through many proposed Medicare

drug benefits, so they would see little change in their drug

use. And for their part, Medicare beneficiaries who lack

drug coverage already use a significant quantity of prescription drugs. (On average, they filled 25 prescriptions

in 1999, compared with 32 for Medicare beneficiaries

who had drug coverage, CBO estimates.)22 The additional, or more expensive, drugs that they might use as a

result of gaining coverage would probably provide lessdramatic or less-immediate improvements in their health

than do the drugs they are currently taking.

Second, any improvements in health would probably

delay rather than prevent the use of expensive health care

services. Delaying the onset of disability or end-of-life

care is unquestionably a good thing, but it also means

that what is saved in one year may be spent a few years

later. Moreover, to the extent that a drug benefit helps

people live longer, they may consume more health care

over their remaining lifetime than they would have without the benefit.

21. See, for example, H. Kaisu and others, “Inappropriate Drug Prescribing in Home-Dwelling Elderly Patients,” Archives of Internal

Medicine, vol. 162 (August 12/26, 2002), pp. 1707-1712; R.R.

Aparasu and S.E. Fliginger, “Inappropriate Medication Prescribing

for the Elderly by Office-Based Physicians,” Annals of Pharmacotherapy, vol. 31, no. 7-8 (July-August 1997), pp. 823-829; and

General Accounting Office, Adverse Drug Events: The Magnitude

of Health Risk Is Uncertain Because of Limited Incidence Data,

GAO/HEHS-00-21 (January 2000).

22. That estimate is based on the 1999 Medicare Current Beneficiary

Survey, with adjustments for underreporting and for use of drugs

by beneficiaries in nursing homes and other long-term care facilities. 
34 ISSUES IN DESIGNING A PRESCRIPTION DRUG BENEFIT FOR MEDICARE

Impact on Medicare+Choice

As of August 2002, about 14 percent of Medicare beneficiaries were enrolled in Medicare+Choice plans.23 In the

past, those managed care plans were attractive to enrollees

because they offered benefits beyond the basic Medicare

package—the most desirable of which was prescription

drug coverage. In recent years, however, changes in payment rates that have lagged behind growth in plans’ costs

have led some plans to withdraw from Medicare and

others to raise enrollees’ premiums or reduce drug coverage and other extra benefits. Consequently, enrollment in

Medicare+Choice fell by 1.4 percent in 2001 after growing by 4.8 percent the previous year.

Adding a prescription drug benefit to Medicare would

affect M+C plans in two ways. Plans that offer drug coverage would receive payment for the value of that coverage rather than having to finance it from their savings on

administration or benefits. M+C plans have cited the

rising cost of prescription drugs and the lack of Medicare

payment for drug coverage—combined with the 1997

changes in payment rates—as reasons for dropping out of

Medicare. Additional payment to cover the cost of a prescription drug benefit would help stabilize participation

by M+C plans (in the absence of other disincentives to

participate).

At the same time, the availability of drug coverage in

regular fee-for-service Medicare would remove one of the

principal incentives for new beneficiaries to select M+C

plans. Such plans would have to differentiate themselves

from fee-for-service Medicare through lower out-ofpocket costs, smaller premiums, or bigger benefits. However, the universal availability of drug coverage could give

M+C plans a new competitive advantage over fee-forservice Medicare: because M+C plans provide the full

package of Medicare benefits for enrollees, they would

have greater flexibility than new plans that provided only

drug benefits to substitute medical services for prescription drugs in a cost-effective manner.

23. Lori Achman and Marsha Gold, Medicare+Choice and Medicare

Beneficiaries: Monthly Tracking Report for August 2002, no. 42

(Washington, D.C.: Mathematica Policy Research, September 5,

2002).
CHAPTER



Cost Estimates for Specific Proposals

7he various design choices described in Chapters 2

and 3 have a significant impact on the costs of a proposed

Medicare drug benefit. The effects of those choices are

complex and interdependent. To illustrate the overall

impact, this chapter presents the Congressional Budget

Office’s cost estimates for four proposals, all of which

were developed at the time of the 106th Congress (1999

to 2000). Those proposals are:

 The drug benefit described in the Clinton Administration’s June 2000 Mid-Session Review;

 The Robb amendment (introduced by Senator Charles

Robb as amendment 3598 to H.R. 4577);

 H.R. 4680 (introduced by Congressman William

Thomas), which passed the House of Representatives

in October 2000; and

 Breaux-Frist II (S. 2807, introduced by Senator John

Breaux).

Those proposals cover a broad spectrum of approaches

for delivering a Medicare drug benefit. For example, H.R.

4680 and Breaux-Frist II would have private-sector entities (such as pharmaceutical benefit management companies or health insurers) compete for enrollees and assume

insurance risk for their drug spending. By contrast, the

Clinton Administration’s proposal would have those entities compete to be selected as the single nonrisk plan in

each region to administer the Medicare drug benefit. Like

H.R. 4680 and Breaux-Frist II, the Robb amendment

would have multiple plans compete for enrollees in each

area, but they would not bear insurance risk.1

To estimate the costs of a proposed Medicare drug benefit, CBO uses a model that simulates how a given proposal would affect the spending of a representative sample

of Medicare beneficiaries. The model contains detailed

information about beneficiaries’ spending for prescription

drugs and Medicare-covered services, their supplemental

insurance coverage (both public and private), their health

status, and their income.2

 CBO’s cost estimates result

from the operation of that model; the effects of specific

design choices cannot be quantified independent of a

proposal’s complete design specifications.

The primary factor that determines the federal costs of a

given drug benefit is how much of enrollees’ current drug

spending the new Medicare benefit would cover. That

amount, in turn, depends on the structure of the coverage

and the number of people who would enroll. But CBO’s

1. Under the Robb amendment, the Secretary of Health and Human

Services could (but would not be required to) link a plan’s payments to certain performance standards proposed by the plan in its

bid to be allowed to offer the Medicare drug benefit. Those standards could include cost control. However, given the vagueness of

the proposal’s language, CBO has interpreted that provision as not

requiring plans to bear insurance risk.

2. The estimates in this chapter are based on data from Medicare

claims for 1999 and from the 1999 Medicare Current Beneficiary

Survey, projected forward using CBO’s March 2002 economic

assumptions and baseline projections of Medicare spending.
36 ISSUES IN DESIGNING A PRESCRIPTION DRUG BENEFIT FOR MEDICARE

estimates also assume that besides simply redistributing

who pays for drug spending, the new benefit would cause

enrollees to change their behavior. Some might fill more

prescriptions or use more brand-name drugs once they

gained better insurance coverage, thus increasing overall

drug spending. The new Medicare benefit might also give

manufacturers greater room to raise prices on certain

drugs (if enrollees became less sensitive to the price of

their prescriptions). Conversely, spending could fall if the

entities that administered the drug benefit made aggressive use of cost-management tools, which can result in

substantial price discounts and changes in the mix of

drugs prescribed or purchased.

CBO’s Key Assumptions

The issues discussed in the previous chapters would affect

both the value of the drug benefit that enrollees receive

and its costs to the federal government. CBO’s approach

takes those issues into account through six key assumptions that are incorporated in the estimating model:

 Beneficiary participation rate—the percentage of Medicare beneficiaries who would enroll in the drug program. CBO assumes that the beneficiary participation

rate is directly related to the share of total premium

costs subsidized by the government.3

 The pool of potential enrollees includes beneficiaries who currently

lack drug coverage, people who would use the new

Medicare benefit to replace their private drug coverage,

and those who would keep their private coverage as a

supplement to the new Medicare benefit.

 Price effect—the percentage increase in drug prices for

the Medicare population that would gradually occur as

a result of the new benefit. A benefit that covered a

larger share of enrollees’ total drug spending would

tend to generate greater price increases than less comprehensive benefit packages would. (Any mitigating effect of cost management on price increases is captured

in the cost-management factor described below.)

 Cost-management factor—a measure of a proposal’s

potential for reducing spending on drugs below what

would be spent by people whose purchases were not

managed. The cost-management factor represents the

net effect of an amalgam of price discounts and rebates, utilization controls, and other tools that a PBM

might use to hold down spending. CBO assumes that

PBMs would have greater incentive and ability to control spending under proposals in which they had to

compete for enrollees and assume insurance risk for

their spending and in which they had broad flexibility

to manage enrollees’ behavior through tools such as restrictive formularies.

 Induced demand—the increase in enrollees’ spending

on prescription drugs as a result of the insurance coverage provided by the new Medicare benefit. CBO

assumes that enrollees’ drug spending would rise by

3 percent for each 10 percent drop in their out-ofpocket costs under the benefit.4

 As is the case with the

price effect, induced demand is directly related to the

relative generosity of the proposed drug coverage. The

overall effect on spending per enrollee is the net result

of induced demand, the price effect, and the cost-management factor.

 Marketing costs—the additional costs associated with

acquiring members and administering drug plans

when multiple plans must compete for enrollees in

each region. Those costs could be lower if plans used

standardized marketing materials that allowed potential enrollees to compare plans more easily, with Medicare providing general information about the available

choices. CBO assumes that marketing costs would be

fairly high in the early years of a Medicare drug program because plans would need to make all Medicare

beneficiaries in their area aware of their services. In

later years, marketing costs would decline because

plans would focus on smaller numbers of people

(mainly those who were newly eligible for Medicare).

3. In CBO’s model, “premium costs” refers to the total value of the

benefits paid out plus the cost of administering the drug program.

4. In economists’ terms, CBO assumes that the elasticity of demand

for prescription drugs is -0.3. As used in this study, “out-of-pocket

costs” include cost-sharing expenses but not an enrollee’s share of

premiums.
CHAPTER FOUR COST ESTIMATES FOR SPECIFIC PROPOSALS 37

 Risk-premium costs—a measure of the additional resources required by private plans if they bear insurance

risk. Those resources could represent the pool of financial reserves needed to cover future drug claims if benefit spending is higher than a plan anticipates, or the

price of private reinsurance that a plan would need in

order to limit its risk, or both. CBO assumes that the

risk premium would be higher in the initial years of a

Medicare drug program because plans would have

little data from which to predict the future cost of

their benefits.

Details of Four Recent Proposals

This section looks at the key assumptions that CBO used

for its cost estimates of four Medicare drug proposals

introduced during the 106th Congress. For the past few

years, when CBO has updated its 10-year projections of

drug spending by or for Medicare beneficiaries, it has also

updated its estimates for those proposals as a way to evaluate the results of its estimating models and reassess key

assumptions. The four proposals are particularly useful

for that effort because they represent a broad spectrum of

approaches in terms of both the scope of the benefit packages and the diversity of ways in which Medicare might

administer a drug program.

Because the four proposals were introduced several years

ago, their original versions would have started the drug

benefit in 2002 or 2003, giving Medicare two or three

years to set up the program. For purposes of the estimates

presented here, CBO assumes that each proposed benefit

would begin in 2005.

In spite of the shift in timing, CBO retained the proposals’ original values for deductibles, benefit caps, and limits

on out-of-pocket spending, rather than adjusting them

for inflation. For example, if a proposal called for a $250

deductible and a $5,000 stop-loss provision beginning in

2003, the estimates described here use those same values

of $250 and $5,000 for 2005. (Each of the proposals calls

for increasing the values of its benefit parameters after the

first year of the program, which CBO also does in its

estimates.) Keeping the same nominal values when drug

spending is growing makes a proposal’s deductible and

stop-loss amounts relatively more generous, whereas keeping the same value for a cap on benefits makes a proposal

less so. As a result of that approach, most of the proposals

examined here are more generous than when they were

introduced.

All four proposals would offer the drug benefit as a voluntary program (called Part D of Medicare), but they

would allow beneficiaries only a one-time opportunity to

enroll without penalty. (If beneficiaries delayed enrollment, they would pay a penalty related to their expected

benefit costs when they did sign up.) Without that provision, CBO would assume much lower rates of participation and much higher costs per enrollee for each proposal,

because people would tend to postpone enrollment until

their drug spending became relatively high.

In general, CBO assumes that all enrollees in Part B of

Medicare would participate in a drug benefit that subsidized at least 50 percent of their premiums, so long as the

proposed drug program met the following criteria:5

 It offered a one-time option to enroll, coupled with an

actuarially set penalty for late enrollment;

 Beneficiaries were enrolled in the drug benefit by default;

 Premium payments were withheld from an enrollee’s

Social Security check in the same manner that Part B

premiums are withheld now;6

 and,

 There were significant subsidies for low-income enrollees.

That approach includes a few exceptions, however. For

example, CBO assumes that the 3 percent of Part B en5. CBO also assumes that Medicare beneficiaries who choose not to

participate in Part B—where 75 percent of premiums are paid by

the government—would refuse to enroll in any drug benefit with a

lower subsidy rate. 

6. CBO uses a higher subsidy “hurdle” when private plans rather

than the Social Security Administration would administer the enrollment and premium-payment processes. In that case, a 75 percent federal subsidy would be necessary to achieve 100 percent

participation.
38 ISSUES IN DESIGNING A PRESCRIPTION DRUG BENEFIT FOR MEDICARE

7DEOH 

Provisions of Four Prescription Drug Proposals for Medicare

Clinton

Mid-Session 

Review Plan

Robb

Amendment H.R. 4680

BreauxFrist II

Benefit Amounts (Dollars)a

Deductible None 250 250 250

Benefit cap 1,000 None 1,050 1,050

Stop-loss amount 4,000 4,000 6,000 6,000

Benefit Administrator SSA SSA Plans SSA

Subsidies for Employment-Based

Health Plans Yes Yes Nob Nob

Number of Plans in Each Region One At least two At least two At least two

Plans Bear Insurance Risk No No Yes Yes

Federal Subsidy for All Enrolleesc 50% subsidy of

premium costs

below stop-loss

amount; 100% above

50% subsidy of 

premium costs

No subsidy of

premium costs;

graduated 

reinsurance rate, 

averaging 35%d

25% subsidy of

premium costs

below stop-loss

amount; 80%

reinsurance above

Source: Congressional Budget Office.

Note: SSA = Social Security Administration.

a. The amounts that would apply in the Medicare drug benefit’s first year of operation, which is assumed to be calendar year 2005.

b. Employment-based health plans for retirees could participate as entities that provide a Medicare drug plan, with the same federal subsidy as other plans.

However, no attempt was made to estimate what share of total enrollment in the drug benefit they would account for.

c. “Premium costs” refers to the total value of the benefits paid out plus the cost of administering the drug program.

d. Today, the enrollee spending levels specified in H.R. 4680 at which federal reinsurance would be paid would lead to a federal subsidy of more than 35 percent.

However, the legislative language caps that subsidy at 35 percent. Thus, the spending levels at which the federal government paid reinsurance would need to be

raised.

rollees who are active workers and have drug coverage

through their employer would keep that primary coverage

rather than sign up for the Medicare benefit.7

 In addition,

CBO assumes that Part B enrollees who also qualify for

the Federal Employees Health Benefits (FEHB) program

or the military’s Tricare for Life (TFL) program would be

less likely to participate in a new Medicare drug benefit

because they already have fairly generous drug coverage.

Unless FEHB and TFL beneficiaries were forced to enroll

in a Medicare drug plan (which current law would not

permit), some might find that the premium for Part D

was not worth the additional benefits.

The Clinton Administration’s Proposal 

The proposal included in the Clinton Administration’s

2000 Mid-Session Review called for a Medicare drug benefit that would have no deductible and would pay 50 percent of an enrollee’s drug spending up to a limit of

$1,000 in 2005 (see Table 5). Once a participant incurred

$4,000 in out-of-pocket costs during the year, Medicare

would cover 100 percent of further drug spending. Under

the proposal, plans would have the flexibility to vary their

enrollees’ coinsurance rates if they could demonstrate that

7. That assumption is a simplifying one. Some of the 3 percent

might enroll in a Medicare drug benefit, but under Medicare’s

secondary-payer rules, their employer’s plan would pay first and

thus would offset some of Medicare’s costs.
CHAPTER FOUR COST ESTIMATES FOR SPECIFIC PROPOSALS 39

the lower cost sharing would not raise costs for the Medicare program; that is, more-generous benefits would be

offset by more-effective cost management.

The Secretary of Health and Human Services (HHS)

would set a uniform national premium for the drug benefit. Under the Clinton proposal, enrollees’ premiums

would cover just half of a plan’s benefit spending below

the catastrophic cap and none of the spending above it.

As a result, CBO estimates that if the drug program began operating in 2005, the federal government would

subsidize 76 percent of benefit spending and administrative expenses for enrollees. Their share of premiums

would amount to $30 a month in 2005, rising to $71 per

month by 2012 (see Table 6).

Enrollees with income of up to 150 percent of the federal

poverty level would receive assistance in paying their

premiums; those with income of up to 135 percent of the

poverty level would also get help in paying their costsharing amounts, including any spending above the benefit cap and below the stop-loss amount (the “hole”). In

addition, Medicare would offer a subsidy to employmentbased health plans to encourage them to remain the primary payer for their retirees’ drug coverage. That subsidy

would equal 67 percent of the premium subsidy that

Medicare would have paid if a plan’s retirees had enrolled

in the Part D benefit.

CBO assumed that 86 percent of Part B enrollees would

participate in the drug benefit, and another 7 percent

would receive drug coverage indirectly through federal

subsidies to employment-based plans. The remaining

7 percent of Medicare beneficiaries would not take part in

the drug program but would continue to have drug coverage through their current employer, FEHB, or TFL.

Under the Clinton Administration’s proposal, PBMs or

other entities would compete to be the sole Medicare

drug plan in each geographic area for a specified period of

time. PBMs would not bear insurance risk for the drug

spending of their enrollees, and they would face some restrictions in the cost containment approaches they could

use. For example, they would have to set dispensing fees

high enough to ensure participation by most retail pharmacies. In addition, enrollees would be guaranteed access

to any drug that the prescribing physician certified as

medically necessary. For those reasons, and because only

one PBM would be chosen to serve each region, CBO

assigned the proposal a relatively weak cost-management

factor (10 percent).

CBO estimates that the Clinton Administration’s plan

would pay about 29 percent of the total drug costs of all

Medicare beneficiaries—sufficiently generous to raise

drug prices by about 8.5 percent above the level they

would otherwise reach at the end of 10 years. In 2005,

about 8 percent of Medicare’s costs for the benefit would

result from the greater use of drugs induced by the new

coverage.

The Robb Amendment

Among the proposals examined here, the Robb amendment is the only one that would not cap an enrollee’s

benefits. Under that proposal, enrollees would pay a $250

deductible and graduated coinsurance rates—50 percent

until their annual out-of-pocket spending for prescription

drugs reached $3,500, then 25 percent until their out-ofpocket spending reached $4,000. After that amount,

Medicare would cover 100 percent of any additional drug

spending. The entities selected to administer the benefit

would be allowed to waive the deductible for generic

drugs and to lower enrollees’ coinsurance rates if they

could show that the lower cost sharing would be offset by

effective cost management. The Robb plan also includes

low-income subsidies to cover premiums and cost sharing

for enrollees with income of up to 135 percent of the

poverty level and premium assistance for people with

income of up to 150 percent of the poverty level.

Like the Clinton Administration’s plan, the Robb amendment would have the Secretary of HHS set a uniform

nationwide premium. Federal subsidies would cover half

of the cost of benefits and administrative expenses, with

enrollees paying the other half through premiums. Their

share of premiums would be about $67 per month in

2005, growing to $137 per month by 2012.

The Robb proposal would also offer to subsidize employment-based health plans if they remained the primary

form of coverage for their retirees. Under that approach,

Medicare would pay the plans 67 percent of the amount
40 ISSUES IN DESIGNING A PRESCRIPTION DRUG BENEFIT FOR MEDICARE

7DEOH 

CBO’s Assumptions for Four Prescription Drug Proposals

Clinton

Mid-Session

Review Plan

Robb

AmendmentH.R.

4680

BreauxFrist II

Values for Calendar Years 2005 Through 2012

Percentage of Medicare Part B Enrollees Who Would Participate in the Drug Benefit

Direct participation 86 85 75 87

Indirect participation (Through employer subsidy) 7 7 a a

Percentage of Medicare Part B Enrollees Who Would Not Participate in the Drug Benefit

People with other drug coverageb 7 7 75

People without other drug coverage 0 0 18 8

Total (All Medicare Part B Enrollees) 100 100 100 100

Cost-Management Factorc

 (Percent) 10 17.5 30 30

Federal Subsidy of Benefit Costs and Administrative Expenses for Enrollees in

the Medicare Drug Program (Percent) 76 50 32 43

Share of Total Drug Spending by or for Medicare Beneficiaries Paid by the

Federal Government (Percent) 29 21 12 15

Values for Calendar Year 2005

Enrollees’ Share of Monthly Premium (Dollars) 30 67 72 56

Plans’ Marketing and Enrollment Costs (As a percentage of benefit spending) 0 7.8 13.5 11.9

Risk Premiumd

 (As a percentage of benefit spending) 0 0 4.6 5.0

Percentage Increase in Drug Prices Expected Because of New Benefite 0.9 1.5 * 0.1

Percentage of Benefit Costs Resulting from Increased Demand for Drugs Under New Benefitf 7.6 8.9 4.4 5.1

Values for Calendar Year 2012

Enrollees’ Share of Monthly Premium (Dollars) 71 137 119 95

Plans’ Marketing and Enrollment Costs (As a percentage of benefit spending) 0 2.4 4.6 4.1

Risk Premiumd

 (As a percentage of benefit spending) 0 0 3.3 3.6

Percentage Increase in Drug Prices Expected Because of New Benefite 6.8 11.8 0.2 0.5

Percentage of Benefit Costs Resulting from Increased Demand for Drugs Under New Benefitf 9.6 8.7 3.9 4.7

Source: Congressional Budget Office.

Note: * = less than 0.05 percent.

a. Employment-based health plans for retirees could participate as entities that provide a Medicare drug plan, with the same federal subsidy as other plans.

However, no attempt was made to estimate what share of total enrollment in the drug benefit they would account for.

b. Active workers with employment-based coverage or people covered by the Federal Employees Health Benefits program or the Tricare for Life program.

c. The percentage by which drug spending would fall relative to unmanaged purchases. For Breaux-Frist II and H.R. 4680, at-risk plans would have a cost-management factor of 30 percent, and fallback plans (5 percent or less of the total) would have a cost-management factor of 12.5 percent, for an average of about 29

percent. For people with supplemental drug coverage, the ultimate effect is a blend of Medicare’s cost management and that of the supplemental plan.

d. The percentage of total benefit costs required to compensate plans for assuming insurance risk. CBO assumes that competing at-risk plans would require a risk

premium equal to 7 percent of the benefits at risk in the first year of the program, declining to a steady state of 5 percent. Because of reinsurance provisions, 72

percent of benefits would be at risk under Breaux-Frist II, and 65 percent of benefits would be at risk under H.R. 4680.

e. The price effect is usually reported as the expected increase in prices at the end of a 10-year period. The 10th-year values for these proposals are 8.5 percent for

the Clinton plan, 14.7 percent for the Robb amendment, 0.2 percent for H.R. 4680, and 0.6 percent for Breaux-Frist II.

f. For prescription drug spending, CBO assumes an elasticity of demand of -0.3, which means that enrollees’ use of drugs is expected to increase by 3 percent for

each 10 percent drop in out-of-pocket costs.
CHAPTER FOUR COST ESTIMATES FOR SPECIFIC PROPOSALS 41

it would have paid in subsidies if the plans’ retirees had

enrolled in the new Part D drug benefit. 

CBO assumed that 85 percent of Medicare Part B enrollees would participate in this proposal’s drug benefit,

and another 7 percent would receive coverage through the

subsidy to employment-based plans for retirees. As under

the Clinton proposal, the other 7 percent of Medicare

beneficiaries would not participate in the drug benefit but

would retain other coverage.

The Robb amendment envisions a competitive system,

with at least two entities (selected through competitive

bidding) administering the drug benefit in each region.

Medicare would compensate PBMs by paying them an

administrative fee. Those payments could be increased or

decreased on the basis of whether the PBMs met certain

performance standards, such as quality of service, enrollees’ satisfaction, or targets for average spending per

enrollee. PBMs could use restrictive formularies, subject

to rules set by a national committee. However, all drugs

approved for marketing in the United States would have

to be provided if medically necessary, as established

through procedures set by the PBM.

Under the proposal, at least two PBMs would compete

for enrollees in each region, but they would not be subject

to insurance risk for their enrollees’ drug spending. Those

plans would also have fewer explicit restrictions on the

tools they could employ to control drug spending than

under the Clinton Administration’s plan. Consequently,

CBO assigned the proposal a much higher cost management factor (17.5 percent) than the one for the Clinton

plan.

Because of the structure of the proposed benefit, CBO

assigned the Robb amendment the highest price effect of

the four proposals—an increase of nearly 15 percent in

drug prices by the end of 10 years. The Robb proposal

would pay for about 21 percent of total drug spending by

or for Medicare beneficiaries, CBO estimates. In 2005,

about 9 percent of Medicare’s costs for the benefit would

come from enrollees’ increased use of prescription drugs.

H.R. 4680

This proposal, which the House of Representatives passed

in October 2000 but the Senate did not consider, also

envisioned a drug benefit with a $250 deductible. Medicare would pay 50 percent of participants’ drug costs, up

to a cap of $1,050 in the first year of the benefit. Once

enrollees incurred out-of-pocket costs of $6,000 or more

during the year, Medicare would cover 100 percent of

their drug spending. H.R. 4680 would allow participating plans to offer actuarially equivalent versions of the

standard benefit—subject to certain limitations. 

Low-income subsidies would cover premiums and costsharing expenses for enrollees with income of up to 135

percent of the poverty level, except that they would be

responsible for covering any spending above the benefit

cap and below the stop-loss amount. Enrollees with income of up to 150 percent of the poverty level would be

eligible for assistance with their Part D premiums.

Once approved by the administering agency through a

process of negotiation, plans would compete for enrollees

in a region on the basis of premiums, access to drugs, and

quality of service. Unlike the two proposals discussed

above, H.R. 4680 would require those plans to assume

significant insurance risk. It would also allow them to use

a broad array of tools to control their enrollees’ drug

spending.

The federal government would ensure that at least two

plans were available in each area, one of which could be a

Medicare+Choice plan offering drug coverage. Employment-based health plans for retirees would also be eligible

to participate directly as entities themselves. In any area

not served by at least two plans, Medicare would have

authority to offer financial incentives (such as a partial

underwriting of risk) to encourage plans to operate in that

region.

Rather than having one nationwide premium set by

Medicare, H.R. 4680 would allow entities to set their

own premiums. As a result, premiums would vary geographically and among plans. On average, enrollees would

pay about $72 per month in premiums in 2005 and $119

per month by 2012.
42 ISSUES IN DESIGNING A PRESCRIPTION DRUG BENEFIT FOR MEDICARE

Unlike in the other proposals, the federal government

would not provide an across-the-board subsidy of each

plan’s premium. Instead, it would make reinsurance payments to plans for the spending of very high cost enrollees; in total, those payments would amount to 35 percent

of the total cost of benefits paid out under the Part D

program. Since plans would also incur costs for bearing

risk and marketing to enrollees, CBO estimates that the

federal government would pay for about 32 percent of

plans’ total spending.

Given that the proposal would offer a federal subsidy of

less than 50 percent and that private entities would run

the enrollment process and collect premium payments,

CBO estimated that only about 75 percent of Part B enrollees would participate in the drug benefit under H.R.

4680. Another 7 percent of Part B enrollees would obtain

drug coverage through their employer (because they are

still active workers) or through FEHB or TFL. The remaining 18 percent of Medicare beneficiaries would not

have drug coverage.

Compared with the other proposals, H.R. 4680 was assigned a relatively high cost-management factor (30 percent). The proposal would give plans greater incentive to

control costs because they would be at risk for their enrollees’ drug spending. They would also have relatively

greater authority because they would face fewer restrictions on their cost-management tools. However, CBO

estimates that a small share of enrollees (5 percent or less)

would be served by fallback plans, which would bear

much less risk and thus would not manage costs as

tightly.

The benefit under H.R. 4680 would pay approximately

12 percent of Medicare beneficiaries’ total drug costs.

The relatively small benefit would cause very little increase in drug prices—0.2 percent by the end of 10 years,

CBO estimates. Induced demand, which would result

because certain enrollees gained better insurance coverage,

would account for slightly more than 4 percent of Medicare’s costs in 2005.

Breaux-Frist II

This proposal has the exact same benefit structure as H.R.

4680 and a similar subsidy for low-income enrollees, but

the federal subsidy for all enrollees differs. Whereas the

House-passed bill would provide all of its federal subsidy

through individual reinsurance payments for high-cost

enrollees, Breaux-Frist II would subsidize 25 percent of

premium costs below the $6,000 catastrophic cap and

subsidize 80 percent of stop-loss benefits through individual reinsurance. CBO estimates that the combination of

those two types of subsidies would total about 43 percent

of premium costs.

Multiple risk-bearing plans would offer the benefit in

each region, and premiums could vary geographically and

among plans. (Enrollees’ share of premiums would average $56 per month in 2005 and $95 per month in 2012,

CBO estimates.) However, unlike in H.R. 4680, the

Social Security Administration would administer enrollment and collect premiums. Because of the higher federal

subsidy and the near-automatic nature of SSA administration, CBO assumed higher participation: 87 percent of

Part B enrollees. Another 5 percent would obtain drug

coverage through their current employer, FEHB, or TFL,

leaving 8 percent of Medicare beneficiaries without drug

coverage.

PBMs would have the same incentives and authority to

contain costs under this proposal that they would have

under H.R. 4680, so CBO assigned the same cost-management factor (30 percent). Plans’ marketing and enrollment costs would be somewhat lower under Breaux-Frist

II than under H.R. 4680, because SSA would bear the

cost of enrolling people and collecting their share of premiums. However, a plan’s insurance-risk premium would

cost more under this proposal because a higher share of

total benefit costs would be at risk: 72 percent rather than

65 percent.

Although the two proposals envision identical benefit

structures, Breaux-Frist II would have a slightly larger

effect than H.R. 4680 would on drug prices (an increase

of 0.6 percent by the end of a 10-year period) because of

higher enrollment. In all, that proposal would pay for

about 15 percent of total drug spending by or for

Medicare beneficiaries. Induced demand for prescription

drugs would account for about 5 percent of Medicare’s

costs in 2005.
CHAPTER FOUR COST ESTIMATES FOR SPECIFIC PROPOSALS 43

Cost Estimates for the Four Proposals

Of the four proposals described above, the Clinton Administration’s would be the most expensive, CBO estimates. It would cost the federal government a total of

$512 billion between 2005 and 2012 (the last year of the

current budget window), followed by the Robb amendment at $374 billion (see Table 7). The two proposals that

have the same benefit structure but different federal subsidies, Breaux-Frist II and H.R. 4680, would be less costly

to the federal government—$233 billion and $195 billion, respectively, over eight years. Those totals reflect

additional costs for Medicare partly offset by savings for

other federal programs.

The federal costs of a particular drug benefit depend

largely on the extensiveness of the coverage and on what

share of that coverage the government would pay for.

Thus, the Robb and Clinton plans—which would pay for

20 percent to 30 percent of total drug spending by or for

Medicare beneficiaries—would have the highest costs to

Medicare. H.R. 4680 and Breaux-Frist II—which would

pay 12 percent to 15 percent of Medicare beneficiaries’

total drug costs—would have lower costs to the Medicare

program.

A new Medicare drug benefit would affect not only Medicare’s costs but also those of other federal programs—

especially Medicaid, Tricare for Life, and the Federal

Employees Health Benefits program. Any expansion of

Medicare benefits would reduce those programs’ health

care costs for beneficiaries who were also eligible for

Medicare. In the case of Medicaid, the federal government would have to pay less in matching contributions to

state Medicaid programs for their spending on prescription drugs.

The savings to other federal programs from a Medicare

drug benefit would be similar under the Clinton and

Robb proposals—$145 billion and $142 billion, respectively, over the 2005-2012 period—because the two plans

are nearly the same in terms of the scope of their drug

coverage. Savings would be significantly smaller under

H.R. 4680 and Breaux-Frist II—$84 billion and $78 billion, respectively—because those proposals would cover

less of their enrollees’ drug spending.

Each of the four proposals includes provisions that would

subsidize all or part of the premium and cost-sharing

expenses for low-income enrollees. As Table 7 shows, the

7DEOH 

Federal Costs of Four Prescription Drug Proposals, 2005-2012

(By fiscal year, in billions of dollars)

Clinton

Mid-Session

Review Plan

Robb

Amendment H.R. 4680

BreauxFrist II

Federal Mandatory Spending on Prescription

Drug Benefits for Medicare Beneficiaries

Medicare 507 342 120 178

Other federal programsa -145 -142 -84 -78

Low-income subsidy 128 148 141 123

Other Mandatory Spending 22 27 18 10

Total 512 374 195 233

Source: Congressional Budget Office.

Note: These numbers exclude a small amount of appropriated funds for federal administrative costs.

a. Principally Medicaid, the Federal Employees Health Benefits program, and the military’s Tricare for Life program. Negative numbers indicate savings.
44 ISSUES IN DESIGNING A PRESCRIPTION DRUG BENEFIT FOR MEDICARE

costs of those low-income subsidies can be quite large: in

the case of H.R. 4680, surpassing even the costs to the

Medicare program itself. The costs of the low-income

subsidy are fairly similar among the four proposals—

ranging from $123 billion to $148 billion over eight

years. The reason for that similarity is that the differences

in coverage among those Medicare drug benefits, which

affect the subsidies for cost sharing, tend to be offset by

differences in enrollees’ premiums.8

 In other words, if a

Medicare benefit covered less drug spending, the lowincome subsidy would be responsible for picking up more

enrollee cost sharing. However, premiums for such a

benefit would also tend to be lower, offsetting some of

the cost-sharing expense.

In addition to the costs described above, a Medicare drug

benefit would have other effects on federal spending. One

is the additional cost that Medicaid and Medicare would

incur if, as CBO expects, the low-income subsidies available under the drug benefit led more Medicare beneficiaries to apply for Medicaid benefits. Those new dual eligibles would increase costs for Medicaid, which would have

to cover their cost-sharing expenses under Medicare. That

increase would also raise Medicare’s costs for those beneficiaries, because their use of covered services would rise.

Another effect comes from provisions in certain proposals

under which the federal government would keep some of

the windfall savings that states would enjoy when a new

Medicare drug benefit displaced state Medicaid drug

spending. Such provisions tend to lower federal costs. A

third effect is that of higher prices for prescription drugs

in other federal programs (such as FEHB and TFL) that

provide coverage to some Medicare enrollees. The line

labeled “Other Mandatory Spending” in Table 7 shows

the net impact of those effects.

8. CBO’s estimate for the Clinton proposal assumes that the lowincome subsidy would pay all drug costs in the hole between the

benefit cap and the catastrophic stop-loss limit. The Robb proposal has no such hole because it has no benefit cap. For H.R.

4680 and Breaux-Frist II, the low-income subsidies would not

cover the hole.
APPENDIX

$

Formulary-Based Strategies for Cost Control

Used in the Private Sector

$key management tool that private-sector health

plans and their pharmacy benefit managers (PBMs) use to

control costs is drug formularies. A formulary is a list of

drugs that a health plan will cover.1

 Formularies are

generally created by pharmacy and therapeutics (P&T)

committees that health plans (or employers that sponsor

plans) establish to evaluate new drugs and to compare the

clinical and economic characteristics of different drugs

prescribed for the same medical condition. When a P&T

committee judges two or more products to be therapeutically equivalent, it may recommend that only one of the

products be included in the formulary. The health plan

might pay part of its patients’ costs for formulary drugs

but would expect patients to pay the full price for any

nonformulary drug—thus giving its enrollees a big

incentive to choose formulary drugs. (Most plans that use

a formulary have a process whereby enrollees can request

exceptions to the formulary.) 

Formularies can save money for health plans in two ways.

First, to the extent that a formulary includes lower-priced

drugs, any shift in prescribing patterns from nonformulary to formulary drugs will save money. Second, manufacturers may give price concessions—usually in the form

of rebates—to a plan as an inducement to have their

products included in the formulary.

Drug-Preference Systems

In recent years, health plans have moved away from the

traditional all-or-nothing formulary to a less rigid set of

rules based on degrees of preference. In those preference

systems, the health plan pays some share of the cost for all

prescription drugs approved by the Food and Drug Administration (except any drugs specifically excluded, such

as certain “lifestyle” drugs), but that share is larger for

“preferred” drugs than for others. Preference systems still

give enrollees an incentive to use preferred drugs, but the

difference in out-of-pocket cost is not as great as with allor-nothing formularies. Also, preference systems generally

do not include a process for exceptions.

The way in which a plan computes its share of a drug’s

cost under a preference system is critical in determining

how much the drug benefit will ultimately cost both the

plan and its enrollees. Preference systems feature three

basic reimbursement structures:

 Tiered copayments, in which enrollees pay a fixed dollar

copayment to a network pharmacy for drugs on the

preferred list and a higher fixed copayment for other

drugs (such as $10 per prescription for a preferred

drug and $25 for a nonpreferred drug). For its part,

the plan agrees to pay the pharmacy the difference

between the full cost of the drug and that copayment.

The full cost of the drug is usually negotiated with

dispensing pharmacies in the PBM’s network. Typically, that cost is based on an estimate of the pharmacy’s cost of acquiring the drug’s ingredients, plus a

negotiated fee for dispensing the prescription.

1. Most hospitals also use formularies to determine what drugs they

will stock or dispense. A formulary usually takes one of two forms:

listing only those drugs that are covered (a closed formulary), or the

mirror image, listing only those drugs that are not covered (an open

formulary). This appendix focuses on closed formularies. 
46 ISSUES IN DESIGNING A PRESCRIPTION DRUG BENEFIT FOR MEDICARE

 Graduated coinsurance rates, in which the plan pays the

pharmacy a higher percentage of the full prescription

cost for a preferred drug than for a nonpreferred drug

(for example, 80 percent for a preferred drug and

50 percent for a nonpreferred drug). Enrollees pay the

rest.

 Reference pricing, in which the plan pays the pharmacy

a specified share of the full cost for a preferred drug

and a dollar amount for a nonpreferred drug that

equals what it would pay for a “reference” drug (a preferred drug that the P&T committee deems to be

therapeutically equivalent to the nonpreferred drug).

The enrollee pays the pharmacy the difference between

the cost of the nonpreferred drug and the plan’s share

of the cost of the reference drug.

Tiered copayments are the arrangement used most frequently in private-sector drug plans today. In that system,

the enrollee’s financial exposure is capped at the highest

copayment, and the enrollee’s financial incentive to

switch to a preferred drug is limited by the difference

between the fixed copayments. The tiered-copayment system protects consumers against uncertainty about price

differences between drugs when they enroll in a health

plan and also against high out-of-pocket costs for very

expensive drugs. However, it also partially shields consumers (or their physicians) from considering the tradeoffs between medical benefits and price when wide differences exist between the actual prices of preferred and

nonpreferred drugs.

Graduated coinsurance rates expose consumers to differences in drug prices more than tiered copayments do and

thus make them more sensitive to price differences in

their prescription choices. However, consumers are still

insulated from the full price differences between preferred

and nonpreferred drugs. Because enrollees’ out-of-pocket

costs vary with the price of a drug as well as with its status

on the preferred list, enrollees can be uncertain about the

extra cost associated with buying a nonpreferred drug.

Reference pricing exposes enrollees to the full price differences between preferred and nonpreferred drugs while

still providing some reimbursement to enrollees who buy

nonpreferred drugs. The greater the price difference between the preferred drug and its nonpreferred alternative,

the more attractive the preferred drug appears. If the

plan’s contribution to the cost of the preferred drug is

high, consumers will face little cost in obtaining that

drug, even if it is very expensive. However, when they enroll in a plan, patients face uncertainty about how much

they will have to pay for a nonpreferred drug, because

that amount depends on the difference between its price

and the price of the preferred drug. Plans, by contrast,

have more certainty about their own spending than they

do with either tiered copayments or graduated coinsurance rates, because their payment does not depend on the

consumer’s choice between preferred and nonpreferred

drugs.

Effectiveness of Cost Control

for Different Kinds of Drugs

A critical question is how effective each of those drugpreference systems would be in containing overall drug

spending compared with an all-or-nothing formulary or

with no formulary at all. Each system has certain advantages, which depend on the number and kinds of competing drugs in a therapeutic class.

Some drugs have little or no competition—not only because they are protected from generic copy by patents or

other exclusive marketing rights but also because no similar drugs are available on the market. The first drug to

treat a condition that hitherto had no available therapy

would essentially be a one-of-a-kind member of a therapeutic class. As long as no close competitors were developed, neither formularies nor preference systems would

have much effect on the price or use of that drug.2

Some therapeutic classes comprise several drugs, at least

one of which has lost patent protection and is available in

generic form. (Selective seratonin reuptake inhibitors,

2. Plans might resort to excluding certain new drugs from coverage.

The threat of such exclusion could have much the same effect as

formularies would on those drugs’ initial prices. However, it would

be politically difficult—as well as deleterious to patients’ health—

for the administrators of a Medicare drug benefit to exclude highly

effective one-of-a-kind therapies on the basis of price alone.
APPENDIX A FORMULARY-BASED STRATEGIES FOR COST CONTROL USED IN THE PRIVATE SECTOR 47

which treat depression, are an example. Of the five distinct drug molecules in that class, two are available as

generic copies.) When generic versions of at least one

drug in a therapeutic class are available, reference pricing

offers health plans the greatest opportunity to achieve cost

savings in that class. Makers of generic drugs compete

vigorously on the basis of the price at which they sell to

pharmacies. If PBMs have good information about those

prices, they can agree to pay network pharmacies a reference price at or near that level (adding an appropriate

prescription-dispensing fee for the pharmacist). When

enrollees choose to buy a brand-name version of a drug

(or a competing drug that is not available in generic

form), they must pay the full difference in price. 

Some therapeutic classes contain only a few distinct drug

molecules, all of which are protected by patents. (The

new class of Cox-2 inhibitors, for example, contains only

two drugs at present, Vioxx® and Celebrex®, although

several other molecules have been submitted to the Food

and Drug Administration for approval.) For small therapeutic classes such as those, reference pricing might not

be as effective as tiered copayments in reducing costs. A

tiered-copayment system lets a PBM require manufacturers of therapeutically equivalent drugs to bid for preferred

status by offering rebates to the PBM. If the bidding is

confidential, manufacturers will not know what their

competitors may bid, so they will feel pressure to offer

high rebates, and the PBM need not reveal the effective

price offered by competing manufacturers.3

 With a

reference-pricing system, by contrast, manufacturers of

competing drugs would know (or soon learn) their competitors’ prices. For therapeutic classes with only a few

competitors, tacit price collusion could result, with all

firms maintaining prices that were higher than they

would have been under a tiered-copayment system.4

In the end, the amount that plans can save through different methods of enforcing formularies will depend on the

copayments or coinsurance rates chosen for each tier, the

number of tiers selected, and most important, the narrowness with which therapeutic classes are defined. If a P&T

committee considers a broad array of drugs—of widely

different ages and different mechanisms of action against

the same disease—to be therapeutically equivalent, the

opportunities for savings will be greater with reference

pricing.

For example, if Cox-2 inhibitors were classified as part of

the nonsteroidal anti-inflammatory class (which contains

many old drugs with inexpensive generic versions available), a reference-pricing system in which a generic drug

was preferred would cause the health plan to pay little for

the Cox-2 drugs and consumers to bear a high share of

the cost. Fewer enrollees would opt for Cox-2 inhibitors

over the older, cheaper drugs. Conversely, if Cox-2 inhibitors were considered a distinct therapeutic class, the potential for savings would be lessened.

The trade-off for greater savings is that wide therapeutic

classes containing drugs that have lost patent protection

are more likely than narrow classes to reduce incentives

for companies to invest in researching and developing

new drugs.5

 If manufacturers believe that new drugs that

make modest or even major clinical improvements will be

classified in existing therapeutic classes, they will be discouraged from investing in such drugs by the prospect of

lower returns. But at the other extreme, if classes are so

narrowly defined that new drugs with small or even negligible improvements in effectiveness or safety are placed in

their own separate class, drug companies will be encouraged to invest in new drugs that may not be cost-effective.

The effect of wide therapeutic classes on research and development would be greater under reference pricing than

under tiered copayments. The reason is that a tieredcopayment system caps a patient’s out-of-pocket payment, even for drugs that are not preferred, whereas refer3. That would probably not hold true with a Medicare drug benefit if

Medicare required PBMs to pass on rebates to enrollees and the

government at the point of each sale. Under such a rule, manufacturers would be able to learn what effective price the winning bidder had offered, so confidential bidding would be less successful in

forcing price competition.

4. See F.M. Scherer, “How U.S. Antitrust Can Go Astray: The Brand

Name Prescription Drug Litigation,” International Journal of the

Economics of Business, vol. 4, no. 3 (1997), pp. 239-256. 

5. Patricia M. Danzon, “Pharmaceutical Benefit Management: An

Alternative Approach,” Health Affairs, vol. 19, no. 2 (March/April

2000), pp. 24-25.
48 ISSUES IN DESIGNING A PRESCRIPTION DRUG BENEFIT FOR MEDICARE

ence pricing would place no upper limit on the patient’s

out-of-pocket cost. Thus, new drugs with high launch

prices would have a greater disadvantage under a reference-pricing system with wide therapeutic classes than

they would under a tiered-copayment system with the

same therapeutic classifications.
APPENDIX

%

Evidence About How Drug Coverage

Affects the Use of Other Health Care Services

$new Medicare drug benefit could lead to

changes in the use—and, hence, the costs—of other

health care services. People who argue that additional

spending on prescription drugs would be at least partly

offset by savings on other sources of health care (such as

hospitals, physicians, and nursing homes) point to indirect evidence from three types of research:

 Studies of how specific drugs or classes of drugs affect

the use of other health care,

 Studies of how improving access to prescription drugs

(through insurance coverage) for vulnerable subgroups

of the population changes their use of other health

care services, and

 Studies of how the use of more or newer prescription

drugs by defined populations affects their use of other

health care services.

None of those approaches exactly address the question of

how Medicare coverage for drugs might alter the use of

other Medicare services. Moreover, the findings of those

studies are conflicting and, in some cases, difficult to

interpret. 

Studies of Specific Drugs or Classes

Published studies of the impact of specific drugs or drug

classes on the use of health care are, by definition, selective. Many of those studies have concluded that a particular drug or class of drugs would reduce, or has reduced,

the use of expensive health care services.1

In general, such studies suffer from two methodological

problems. First, they may be subject to publication bias—

the tendency of authors to submit, and journals to publish, studies with findings that suggest improvements

from therapy.2

 Second, many of those studies focus on

groups of patients for whom the drug or drug class is

approved for marketing (people who generally show the

greatest positive effect from the drug) and exclude patient

groups for whom the drug might be ineffective or even

1. See, for example, Samuel A. Bozzette and others, “Expenditures for

the Care of HIV-Infected Patients in the Era of Highly Active

Antiretroviral Therapy,” New England Journal of Medicine, vol.

344, no. 11 (2001), pp. 817-823; and the Study of Left Ventricular Dysfunction (SOLVD) investigators, “Effect of Enalapril on

Survival in Patients with Reduced Left Ventricular Ejection Fractions and Congestive Heart Failure,” New England Journal of Medicine, vol. 325, no. 5 (1991), pp. 293-302.

2. See Mark Friedberg and others, “Evaluation of Conflict of Interest

in Economic Analysis of New Drugs Used in Oncology,” Journal of

the American Medical Association, vol. 282, no. 15 (October 1999),

pp. 1453-1457; and Carin Olson and others, “Publication Bias and

Editorial Decisionmaking,” Journal of the American Medical Association, vol. 287, no. 21 (June 5, 2002), pp. 2825-2828.
50 ISSUES IN DESIGNING A PRESCRIPTION DRUG BENEFIT FOR MEDICARE

harmful.3 Consequently, those studies provide little insight into the overall effect of changes in prescription

drug coverage.

Studies of Changes in Access to Drugs

Only a handful of studies address the impact on health

care use of a policy that alters access to prescription drugs.

A major drawback of those studies is that they focus on

the effects of reducing access to prescription drugs among

subgroups of the population who have already been diagnosed with a chronic illness. A study that looked at the

effects of increasing access to a wide variety of prescription drugs among a population that was more representative of all elderly people would be more useful in this

case.

In 1981, New Hampshire changed its Medicaid rules by

limiting to three the number of prescriptions that Medicaid patients could have filled in any month. A well-controlled study of that change found that the use of prescription drugs by elderly patients who were on regular

medication for chronic illnesses declined as a result.4

 Their

nursing home admissions increased, but their hospitalization rates did not. Because people in nursing homes were

exempt from the three-prescription limit, the increase in

nursing home admissions among chronically ill patients

may have been an attempt to obtain needed drugs. The

study did not examine all elderly patients who were subject to the limit; healthier individuals might have had

fewer emergency and inpatient admissions because of

reduced likelihood of harmful drug interactions, side effects, or other adverse drug events.

A more recent study of changes in a drug insurance program for the elderly focused on the Canadian province of

Quebec, which restricted financial access to drugs by

raising cost-sharing rates in 1996 and increasing deductibles in 1997.5

 That study found that use of prescription

drugs declined in patients who, when the first policy

change occurred, had been taking drugs deemed by a

panel of clinicians to be “essential.” Those patients also

had an increased number of emergency room visits and

admissions to hospitals or nursing homes. Patients taking

drugs deemed “less essential” also saw their use of prescription drugs decline, but their use of other health care

services did not increase. (Indeed, they showed a modest,

but statistically insignificant, trend toward reduced hospitalization.) However, those two sets of drugs represented

only about half of all prescriptions filled by the elderly;

the effect of the restrictive financial policies on people

taking other drugs was not studied. Thus, it is impossible

from the study’s results to assess the net effects of those

restrictions on the use of other health care services among

affected individuals.

Two studies of how state pharmaceutical assistance programs for low-income seniors affected the use of other

health services found suggestive evidence that people

enrolled in the programs used hospitals and other sources

of health care less frequently than did other people studied.6

 However, because of data limitations, the methods

used to control for competing factors that might account

for those effects were crude. Consequently, the studies do

not provide much insight into how a Medicare drug benefit could alter the use of other health care services.

3. Thomas Bodenheimer, Conflict of Interest in Clinical Drug Trials: A

Risk Factor for Scientific Misconduct (Department of Health and

Human Services, Office for Human Research Protections, August

15, 2000), available at http://ohrp.osophs.dhhs.gov/coi/bodenheimer.htm; and Laura F. Hutchins and others, “Underrepresentation of Patients 65 Years of Age or Older in Cancer-Treatment

Trials,” New England Journal of Medicine, vol. 341, no. 27 (December 30, 1999), pp. 2061-2067.

4. Stephen B. Soumerai and others, “Effects of Medicaid Drug-Payment Limits on Admission to Hospitals and Nursing Homes,” New

England Journal of Medicine, vol. 325 (October 1991), pp. 1072-

1077.

5. Robyn Tamblyn and others, “Adverse Events Associated with Prescription Drug Cost-Sharing Among Poor and Elderly Persons,”

Journal of the American Medical Association, vol. 285, no. 4 (January 24/31, 2001), pp. 421-429.

6. Earle W. Lingle, K. Kirk, and W. Kelly, “The Impact of Outpatient Drug Benefits on the Use and Costs of Health Care Services

for the Elderly,” Inquiry, vol. 24 (Fall 1987), pp. 203-211; and

Center for Health Policy Studies, EPIC Evaluation Report to the

Governor and Legislature: An Evaluation of New York State’s Elderly

Pharmaceutical Insurance Coverage Program (Columbia, Md.:

CHPS Consulting, no date).
APPENDIX B EVIDENCE ABOUT HOW DRUG COVERAGE AFFECTS THE USE OF OTHER HEALTH CARE SERVICES 51

Results were recently reported for a study that looked at

the difference between three-tiered copayments and twotiered copayments in the use of other medical services by

enrollees in employment-based drug plans.7

 Moving from

a two-tired to a three-tiered copayment system raises the

cost of drugs not included on the preferred-drug list. The

researchers found that in the year after the three-tiered

system was introduced, drug use declined, but no significant differences in use of physicians, hospitals, or emergency medical services occurred. However, most of the

enrollees were active workers and their dependents, who

can be expected to be healthier and less dependent on

prescription drugs than a Medicare population. Also,

preferred drugs were determined by a pharmacy and therapeutics committee and presumably included only those

classes of drug for which adequate choices exist.

Studies of the Effects of More

and Newer Drugs

Two studies by Frank Lichtenberg provide suggestive

evidence that increased use of prescription drugs and substitution of newer for older drugs are associated with

lower use of hospitals and other health care services as

well as lower mortality.8

 In particular, the second of those

studies makes perhaps the strongest case that greater use

of prescription drugs can lead to declines in nondrug

health services. Yet even with Lichtenberg’s relatively

careful approach, that study’s methodology may have

underestimated each patient’s nondrug health spending

and thereby overstated the effects of newer drugs.

The first study related disease-specific changes in rates of

hospital use between 1980 and 1991 to the change in the

volume of prescriptions associated with each disease and

to a disease-specific “drug novelty” index.9

 Increases in

drug volume were correlated with reductions in hospital

admissions, length of stay, and number of surgeries over

the period. (The drug novelty index was also associated

with declines in those measures of hospital use.)

One major problem with that study is that it assumed

that unmeasured determinants of hospitalization rates—

such as changes in hospital payment over the period—

were not correlated with the degree of drug innovation

(novelty) or with changes in drug use for a given diagnosis. But there is reason to believe that such correlation

existed. Third-party payment and regulatory policies

changed dramatically during the study period and encouraged reductions in days of hospital care.10 Common

diagnoses (such as cardiovascular disease) were likely to

offer opportunities for big overall savings in hospital days

as well as big markets for new drugs. Because the novelty

index was based on switches among individual molecules,

diseases with bigger markets would also be expected to

have higher novelty indexes. Similarly, diseases with bigger markets might also provide greater financial incentives

for the development of new diagnostic technologies,

which would increase the number of people receiving

therapy, and at earlier stages of the diseases. Thus, the

study could be biased in favor of attributing too great a

share of the decline in hospital utilization to increases in

drug use and to the substitution of new drugs for old

drugs.

The second study took a different tack. Lichtenberg hypothesized that people who took drugs that came on the

market more recently would use less health care in 1996

(the year for which a survey of health care use was avail7. Brenda Motheral and Kathleen Fairman, “Effect of a Three-Tiered

Prescription Copay on Pharmaceutical and Other Medical Utilization,” Medical Care, vol. 39 (2001), pp. 1293-1304.

8. Frank R. Lichtenberg, “Do (More and Better) Drugs Keep People

Out of Hospitals?” Health Economics, vol. 86, no. 2 (May 1996),

pp. 384-388; and Frank R. Lichtenberg, The Benefits and Costs of

Newer Drugs: Evidence from the 1996 Medical Expenditure Panel

Survey, Working Paper No. 8147 (Cambridge, Mass.: National

Bureau of Economic Research, 2001).

9. The drug novelty index was a measure of the change in the distribution of specific drug molecules prescribed between 1980 and

1991. An index value of zero meant no change in distribution between those years. A value of 1 meant no agreement at all in prescribing patterns between 1980 and 1991.

10. Most notably, in 1984, Medicare began using prospective payment

for hospitals. It also required greater review of hospital admissions

over the period. By 1991, the number of days of hospital care per

1,000 aged Medicare beneficiaries had declined to 2,672, from

3,846 in 1982; see “Medicare/Medicaid Statistical Supplement,

2000,” Health Care Financing Review (June 2001), Table 23.
52 ISSUES IN DESIGNING A PRESCRIPTION DRUG BENEFIT FOR MEDICARE

able) than would people who tended to take older drugs.

Accounting for various characteristics of the patient and

the condition for which a drug was prescribed, use of and

expenditures for all other health care services were lower

when newer drugs were prescribed than when older drugs

were prescribed. The savings, especially in hospital costs,

were substantially larger than the extra costs associated

with using newer drugs. 

The study did not account for hospital admissions or

other health care that might have resulted from adverse

drug events, because those admissions would often be for

conditions not related to the purpose of the drug. (For

example, an admission for liver failure resulting from

long-term use of a cardiovascular drug would not be

counted.) Thus, the study did not fully test whether cost

savings from newer drugs outweighed cost burdens from

adverse drug events. There are other technical questions

about the methods used in the study. Nevertheless, the

magnitude of the net savings estimated by Lichtenberg

suggests that, on balance, patients who took newer drugs

were likely to spend less on other kinds of medical care.