CONGRESS OF THE UNITED STATES

CONGRESSIONAL BUDGET OFFICE

STUD Y

HOW HEALTH CARE REFORM AFFECTS

PHARMACEUTICAL RESEARCH AND DEVELOPMENT

The Congress of the United States

Congressional Budget Office
NOTES

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

Cover photo ®The Stock Market/Gabe Palmer, 1985.
Preface

T

he Congressional Budget Office (CBO) has prepared this report as part of its

continuing analysis of the Administration's and other health care reform proposals. The report contains a general view of the provisions in the Administration's

proposal that concern pharmaceutical benefits and costs. It also examines the effect of

those provisions on the demand for drugs and on the incentives they offer pharmaceutical companies to invest in research and development. In keeping with CBO's mandate

to provide nonpartisan analysis, the report includes no recommendations.

Anna Cook and Philip Webre of CBO's Natural Resources and Commerce Division wrote the study under the supervision of Jan Paul Acton and Elliot Schwartz.

Linda Bilheimer of CBO's Health and Human Resources Division provided extensive

aid and consultation. CBO analysts Leonard Burman, Sandra Christensen, Robert

Dennis, Jon Hakken, Scott Harrison, Harriet Komisar, Charles Seagrave, Paul Van de

Water, and Aaron Zeisler also provided valuable comments and assistance. Outside

CBO, Sarah Glavin, Henry Grabowski, Gary Guenther, Robert Helms, Alison Keith,

Janie Kinney, Joseph Newhouse, B. Randal, F. M. Scherer, Judith Wagner, and Joshua

Weiner all provided useful reviews.

Sherwood Kohn edited the manuscript, and Christian Spoor provided editorial

assistance. Angela McCollough and Donna Wood typed the many drafts. Kathryn

Quattrone and Martina Wojak-Piotrow prepared the study for publication.

Robert D. Reischauer

Director

June 1994

Contents

ONE

TWO

THREE

FOUR

FIVE

SUMMARY

INTRODUCTION

INDUSTRY AND MARKET BACKGROUND

Structure of the U.S.

Pharmaceutical Industry 6

Competition in the U.S.

Pharmaceutical Market 13

Conclusions 16

HOW THE ADMINISTRATION'S PROPOSAL

WOULD AFFECT THE DEMAND FOR

PRESCRIPTION DRUGS

The Administration's Proposal for

Universal Coverage 18

Medicare's New Drug Benefit 22

Conclusions 27

THE REBATE ON MEDICARE PRESCRIPTION

DRUGS AND THE ADVISORY COUNCIL ON

BREAKTHROUGH DRUGS

IX

1

3

17

29

The Medicare Drug Rebate Agreement 29

The Medicare Rebate for New Drugs 31

The Advisory Council on Breakthrough Drugs

Effects on the Pharmaceutical Market 36

The Cost Containment Provisions

in Perspective 38

EFFECTS OF OTHER PROVISIONS

Changes in Medicaid 41

Shifting Patients to Managed

Care Providers 41

Constraining the Rate of Growth

of Health Plan Premiums 43

34

41
vi HOW HEALTH CARE REFORM AFFECTS PHARMACEUTICAL R&D June 1994

SIX

SEVEN

APPENDIXES

A

B

THE EFFECT OF THE ADMINISTRATION'S PROPOSAL

ON THE RETURNS FROM DRUG DEVELOPMENT 45

What Previous Studies of the Returns

from Drug Development Show 45

How the Returns from Drug

Development Would Change 47

Sensitivity of the Results to

the Base-Case Assumptions 57

Conclusions 55

CONCLUSIONS 57

Incentives Provided by the

Medicare Rebate 57

The Changing Pharmaceutical Market 58

The Cost of Capital 61

Calculating the Change in Average

Returns from Drug Development 63

Sensitivity of Profit Calculations

to Product Price Changes 65
CONTENTS

TABLES

S-l.

1.

2.

3.

4.

5.

6.

7.

8.

The Effect of the Administration's Proposal

on the Present Value of Profits Generated Over the

Lifetime of the Average Drug

Primary Source of Health Insurance for the U.S.

Noninstitutionalized Population, by Age, 1993

Induced Demand for Prescription Drugs by the

Under-65 Population Under the Administration's

Proposal for Universal Coverage

Induced Demand for Outpatient Prescription Drugs

by Medicare Enrollees 65 and Over

The Cost of Drug Development Compared with

Profits for the Average Drug

The Effect of the Administration's Proposal on

Average Profits from Developing a Drug: Base Case

The Effect of the Administration's Proposal on

Average Profits from Developing a Drug Under

Varying Assumptions About Induced Demand

The Effect of the Administration's Proposal on

Average Profits from Developing a Drug Under

Varying Assumptions About Marginal Cost

The Effect of the Administration's Proposal on

Average Profits from Developing a Drug for the

65-and-Over Population Under Varying Assumptions

About Producer Price

xiv

20

21

24

46

49

52

53

54

FIGURES

1.

2.

3.

4.

5.

U.S. Prescription Drug Sales

Prescription Drug Spending as a Percentage

of National Health Expenditures

Prescription Drug Spending as a Percentage

of Gross Domestic Product

U.S. Consumer Spending on Pharmaceuticals

Research and Development Spending by the

U.S. Pharmaceutical Industry (In billions of dollars)

6

7

10
viii HOW HEALTH CARE REFORM AFFECTS PHARMACEUTICAL R&D June 1994

6. Research and Development Spending by the

U.S. Pharmaceutical Industry (As a percentage of sales) 11

7. Sales of Ten Companies' Top Three Drugs as a

Percentage of Prescription Sales by Each Firm 12

8. FDA Approval of New Drugs 34

9. How the Change in Average Returns from

Developing a Drug Under the Administration's

Proposal Varies as the Share Consumed by

People 65 and Over Increases 51

BOX

1. Measurement Issues in Pharmaceutical Price Increases
Summary

I

n the fall of 1993, the Administration introduced a comprehensive proposal for health

care reform. The Administration's proposal

attempted to balance the desire for increased access

to medical care with the need to control costs, both

overall and in the specific case of Pharmaceuticals.

This report concentrates on how proposed changes

in health care policy—primarily universal coverage

and improved Medicare benefits-are likely to affect

the size and composition of the pharmaceutical

market and the incentives of drug companies to

engage in research and development (R&D). The

provisions in the Administration's proposal for

health care reform that deal explicitly with pharmaceuticals focus mainly on outpatient prescription

drugs. In general, the insurance status of inpatient

and over-the-counter Pharmaceuticals would not be

changed directly, though the economic incentives

facing those who produce and consume them are

likely to change.

Although the study focuses on the Health Security Act, many of that plan's features are also included in other proposals for health care reform.

Wherever those other proposals contain provisions

similar to the ones examined here, the same analysis

would apply.

Industry R&D and Market

Structure

Pharmaceutical expenditures have been rising both

in real terms and as a share of national health expenditures. The share of prescription drug spending, excluding most over-the-counter drugs, accounted for 6.4 percent of total national health

expenditures in 1991, up from 4.4 percent in 1981.

As a share of gross domestic product (GDP), prescription drug spending rose during most of this

period, reaching 0.8 percent of GDP in 1991. Outpatient prescription drugs account for three-quarters

of all pharmaceutical sales. Other Pharmaceuticals

are administered in inpatient settings, such as hospitals. In 1993, U.S. prescription sales exceeded $55

billion, according to industry figures.

Industry R&D

Research and development in the pharmaceutical

industry (both foreign and domestic) has increased

continuously for the last two decades, both in absolute terms and as a percentage of sales. According

to industry figures, in 1993 domestic R&D funded

by the industry reached $10.3 billion, or 18 percent

of sales. The high level of R&D in this industry,

together with relatively low production costs, has

created a cost structure that encourages companies

to seek ever-larger markets for their products, even

if this requires substantial price discounts. The

reason is that once a product is developed and approved for sale, it has already incurred R&D costs.

Additional sales, even at deep discounts, serve to

spread the R&D costs. The fact that pharmaceutical

companies can offer some consumers price reductions that they do not offer to others also encourages discounting.

The high technical levels fostered by R&D, coupled with a favorable cost structure, have resulted in
x HOW HEALTH CARE REFORM AFFECTS PHARMACEUTICAL RESEARCH AND DEVELOPMENT June 1994

a domestic industry that is very competitive internationally. U.S. firms developed almost half of the

important new drugs-those that are sold in all major markets around the world-that were introduced

between 1970 and 1992. According to the Department of Commerce, U.S. firms sold one-half (by

value) of the world's Pharmaceuticals that were

consumed in 1991.

The Changing U.S. Market

Seventy percent of prescriptions are for drugs that

are manufactured by more than one company. Even

the remaining 30 percent, however, often face competition by substitutes.

On a scale ranging between a perfect monopoly

and perfect competition, the pharmaceutical industry

can probably best be described as imperfectly competitive; firms have some power to raise prices and

generate excess profits. Observers suggest, however, that recent events in the pharmaceutical market

are undercutting this power somewhat and serving

to move the industry in the direction of more competition.

The market is changing. On the supply side,

sales of generic drugs are increasing. On the demand side, buyers exercise more market power to

reduce the profits of the pharmaceutical companies.

Demand-side changes include the spread of companies devoted to managing the pharmaceutical benefits for third-party payers, such as health insurance

companies, and the expansion of the market share of

managed health care providers. Both of these

groups use a variety of techniques to reduce pharmaceutical costs, including aggressive negotiations

with pharmaceutical companies, restrictive drug

utilization lists, and widespread use of generic

drugs. Although the use of these techniques is

growing, only a small fraction of buyers currently

employ them, and even then inconsistently. Still, as

a share of total prescription sales, the volume of

generic drugs has increased from 23 percent in 1980

to almost 40 percent. Furthermore, patents on many

of the top-selling drugs will expire in the next few

years, opening the door to even more competition

among manufacturers of generic drugs.

Provisions That Increase

Demand for Prescription

Drugs

The Congressional Budget Office (CBO) has analyzed two provisions of the Administration's proposal that are likely to increase demand for prescription drugs directly: a universal entitlement to a

comprehensive package of health benefits, including

reimbursement for prescription drugs (universal

coverage), and the addition of a prescription drug

benefit to Medicare, which is the primary source of

health insurance coverage for the population that is

65 years old and older.

CBO's estimate of the change in demand for

Pharmaceuticals omits several provisions of the

Administration's proposal, usually because these

provisions proved impossible to quantify, even

approximately. For example, CBO provides no

estimate of the way in which shifts to managed care

providers would affect the use of prescription drugs,

although anecdotal evidence suggests that managed

care providers use more prescription drugs than do

fee-for-service providers. In addition, incentives

facing providers would change under the Administration's proposal and might affect the use of drugs.

The proposed provision of universal coverage,

including a drug benefit, would increase total prescription drug expenditures by 3 percent to 5 percent. Adding a drug benefit to Medicare would

increase total prescription drug expenditures by 1

percent. CBO estimates that these provisions of the

Administration's proposal would increase total expenditures on all prescription drugs by 4 percent to

6 percent.

Effects of the Administration's

Proposal for Universal Coverage

on Drug Demand

The Administration's proposal would extend health

insurance coverage to all legal residents of the

United States. The under-65 population would be
SUMMARY XI

covered by one of three basic types of plans, each

of which would include coverage for hospitalization,

physician visits, and outpatient prescription drugs.

The drug benefit in the Administration's proposal

for the high-cost-sharing option would pay 80 percent of the cost of prescription drugs after a $250

deductible had been met. If a person were to enroll

in the low-cost-sharing option, he or she would pay

$5 per prescription with no deductible. The combination plan would offer the low-cost-sharing benefits when a patient used a plan's network of health

care providers. Otherwise, the high-cost-sharing

benefits would apply. All three plans would place

an annual limit of $1,500 per individual ($3,000 for

families) on all out-of-pocket medical expenses.

Universal coverage under the Administration's

proposal would have the greatest impact on demand

for prescription drugs by extending benefits to the

37 million people under age 65 who are currently

uninsured. Under the comprehensive benefits proposed, coverage would also improve for another 8

percent of the under-65 population who are insured.

But most of the population under 65 already has

hospital, physician, and drug coverage through an

employer, similar to that included in the Administration's proposal. CBO estimates that universal

coverage, including the proposed drug benefit,

would increase demand by the under-65 population

for all prescription drugs by 5 percent to 7 percent.

It is primarily the demand for outpatient prescription

drugs that would rise. The under-65 population

currently accounts for two-thirds of all prescription

drug sales. Thus, universal coverage would increase

the total demand of the entire population for all

prescription drugs by 3 percent to 5 percent.

Effects of the Administration's

Proposal for Expanded Medicare

Benefits on Drug Demand

Under Medicare, everyone 65 and over and eligible

for Social Security is automatically entitled to hospitalization benefits. So are certain disabled people

under 65 and some people with severe renal disease.

All people who are 65 and over, as well as other

people who are eligible for Medicare's hospitalization benefits, may participate in Medicare's Supplementary Medical Insurance program, which covers

physician, outpatient hospital, and independent

laboratory services. Participants must pay a

monthly premium. Supplementary Medical Insurance, to which the drug benefits would be added,

covers 95 percent of the 65-and-over population.

Under the Administration's proposal, Medicare

beneficiaries would for the first time have a prescription drug benefit as part of their basic coverage. That benefit would be approximately commensurate with the high-cost-sharing option available

for the rest of the population under the Administration's proposal. The benefit would pay 80 percent

of the cost of prescription drugs after a $250 deductible had been met. Once the recipient had paid

$1,000 in out-of-pocket prescription drug expenses,

Medicare would cover all pharmaceutical purchases

for the year. The Medicare Supplementary Medical

Insurance premium would be increased to pay for

one-quarter of the cost of the new drug benefits.

The new Medicare coverage would also encourage

substitution of generic drugs unless otherwise requested by the physician.

By itself, adding the prescription benefit would

not be likely to increase pharmaceutical purchases

by the 65-and-over population dramatically. Just

over half of the 65-and-over population already has

supplemental coverage for prescription drugs, primarily through retirement plans. In addition to the

basic benefits they get from Medicare, most 65-andover Medicare beneficiaries also have supplemental

coverage for physician services. Many analysts

believe that access to physicians is a major factor

determining prescription drug expenditures, perhaps

more important than drug coverage itself. Consequently, CBO estimates that outpatient drug expenditures for the entire 65-and-over population would

rise by only 4 percent if prescription drug coverage

were extended to it as a basic benefit. Currently,

this population accounts for one-third of all prescription drug purchases. The estimated increase in

expenditures for outpatient drugs by Medicare beneficiaries corresponds to a 1 percent rise in the total

prescription drug expenditures of the entire population.
xii HOW HEALTH CARE REFORM AFFECTS PHARMACEUTICAL RESEARCH AND DEVELOPMENT June 1994

Provisions That Control Costs

The Administration's proposal attempts to control

health costs, both directly and indirectly. Most

important, it would control the rate of increase in

the premiums that health plans could charge for the

standard benefit package and would result in major

changes in the structure of the health care marketplace. For prescription drugs, rebates and close

inspection of introductory prices of new drugs may

be the most important direct mechanisms. In addition, indirect effects on the medical care delivery

system, such as through increased enrollment in

health maintenance organizations that may substitute

drugs for surgical or other medical procedures,

could be substantial, but they cannot be measured

without appreciable error and are not analyzed

quantitatively in this study.

Medicare Rebates

In order to reduce the impact of the expanded Medicare benefit on the taxpayer, the Administration's

proposal includes a rebate of at least 17 percent that

pharmaceutical manufacturers would have to agree

to pay to the government on all brand-name (nongeneric) prescription drugs purchased on an outpatient basis by Medicare beneficiaries. (The rebate

on drugs purchased by Medicaid enrollees would

end.) The Medicare rebate would be based on the

"average manufacturer retail price," which is defined

as the price paid to pharmaceutical manufacturers

for drugs that are sold through pharmacies and other

retailers.

The rebate would increase if the difference

between the average manufacturer retail price and

the average price paid by institutional purchasers,

such as hospitals, exceeded 17 percent. In that case,

the rebate would equal the average discount given

to institutional purchasers. If the amount of the

drugs consumed by Medicare beneficiaries was

sufficiently large in relation to the total demand for

the drug, the manufacturer would be likely to keep

the average discount rate afforded institutional purchasers at or below 17 percent.

This rebate would assure that the government

paid no more. on average for a drug purchased

through Medicare than institutional purchasers do,

and would sometimes pay less. The rebate would

probably have a much greater effect on drug company profits than the price discount given to a typical institution. People who are 65 years old or

older account for one-third of prescription drug

sales, but each institution represents only a small

fraction of the total market.

The rebate would also increase if the average

manufacturer retail price of a drug rose faster than

the rate of inflation as measured by the consumer

price index. In addition, manufacturers would not

be able to exclude a portion of their drugs that are

already on the market from the rebate agreement.

Either all of the manufacturer's existing drugs or

none would be covered by Medicare.

Based on a sample of 100 patented drugs on

which the Medicaid program currently spends the

most money, CBO found that the median best discount given to institutional purchasers was 18 percent off the average manufacturer price (approximately the price paid by wholesalers and the Medicaid rebate equivalent of the "average manufacturer

retail price"). Since the average discount given to

institutional purchasers would be lower than the best

discount given to any institutional purchaser, the

average amount that brand-name drugs are discounted for institutional purchasers may often be

below 17 percent.

Discounts are currently smaller than they might

be in the absence of Medicaid rebates. The incentive to give institutional buyers discounts in excess

of 17 percent on drugs purchased by people 65 and

over would diminish, but perhaps no more so than it

has already under the Medicaid rebate agreement.

Medicare Rebates on New Drugs

For any prescription drug that was first marketed

after June 1993, Medicare could negotiate a special

rebate if the Secretary of Health and Human Services (HHS) believed the drug was priced excessively or if the drug was marketed abroad at a lower
SUMMARY Xlll

price. The drug company and the Secretary would

have six months from the date of the approval by

the Food and Drug Administration (FDA) to negotiate a rebate agreement. If HHS and the company

failed to negotiate such an agreement, the Secretary

could refuse to reimburse purchases of the drug

under the Medicare drug benefit. Without this

provision, drug companies would be more likely to

try offsetting the rebate by charging higher launch

prices.

A special rebate could be negotiated if the price

in one or more of almost two dozen foreign—mostly

European—countries was significantly below the

introductory price in the United States. Since it is

unlikely that U.S. introductory prices of any given

drug would be lower than the prices in all of these

countries, all new drugs could be subject to special

rebate negotiations.

Although much of the policy debate has been

focused on breakthrough drugs, imitative ("me too")

drugs also play a major role in the pharmaceutical

market. By providing a therapeutic alternative,

these drugs can make a market more competitive

well before the patent on the original drug expires,

thus limiting the ability of a breakthrough drug's

manufacturer to sustain excessive prices. Under the

Administration's proposal, only generic drugs would

be exempt from the rebate on new drugs. If the

Medicare rebate on new drugs is set too high, it

could discourage competition and early entry.

Given the uncertainty inherent in deciding on a

reasonable price, the rebate provision increases the

risk of launching new drugs. Similarly, if the rebate

is extended to generic drugs, it might also discourage entry. These effects would not be felt immediately because drug companies would probably finish

those projects that are nearing completion.

The actions of Medicare, sometimes in conjunction with the Advisory Council on Breakthrough

Drugs, could give the federal government a major

influence over the prices of many pharmaceuticals.

Under the Administration's proposal, the Secretary

of HHS would negotiate the initial rebate, based on

the "reasonableness" of the launch price. After the

launch period, the Medicare rebate would increase if

a pharmaceutical company raised its prices above

the rate of inflation. Consequently, the federal

government would be sending strong signals to

manufacturers on launch price and subsequent price

increases. The combination of these policies would

not have as much force as formal price controls, but

would go against a longstanding trend of eliminating price and quantity controls and keeping health

and quality regulations.

Advisory Council on

Breakthrough Drugs

Under the Administration's proposal, when any new

drug that represents a significant therapeutic advance is approved by the FDA, the launch price

would be subject to review by a 13-member Advisory Council on Breakthrough Drugs. This council,

appointed by the Secretary of HHS, would be responsible for determining whether a launch price

was "reasonable" or not, basing its judgment on

related and foreign drug prices; manufacturer's

costs, including R&D; various market forecasts; the

cost effectiveness of the drug; and its potential

contribution to the quality of life. The Secretary of

HHS would publish the council's determination,

together with minority opinions, in the Federal

Register. Presumably, the Advisory Council's

judgment would be a significant factor in the

Medicare rebate negotiations and might affect private negotiations as well. Because the council

would deal with all breakthrough drugs, its responsibilities would extend beyond Medicare.

Depending on how the proposed legislation is

interpreted, however, the Advisory Council could

play a role in just a very small number of drug

introductions. Between 1975 and 1991, the FDA

approved an average of 22 new drugs (containing

new active ingredients, or "new molecular entities"

in FDA parlance) per year. The breakthrough category, promising major new therapeutic potential,

accounted for one-seventh of all new molecular

entities, or about three drugs each year. Including

drugs with only modest therapeutic improvement

would increase this number to 11 per year.

Although only a few drugs can be classified as

breakthroughs, many companies undertake their

R&D with the intent of developing just such pharmaceuticals. Thus, even though the number of
xiv HOW HEALTH CARE REFORM AFFECTS PHARMACEUTICAL RESEARCH AND DEVELOPMENT June 1994

drugs directly involved might be small, the inhibiting effect on pharmaceutical companies could be

much greater.

Effects on the Returns from

Drug Development

Underlying the Administration's proposal are two

conflicting effects: the extension of drug benefits to

the entire population could increase the total demand for prescription drugs by 4 percent to 6 percent, boosting profits of pharmaceutical manufacturers; but rebates on drugs sold to Medicare patients

and other cost controls could limit profits (or returns). The net effect on returns from drug development would be small and positive when averaged

among all drugs, but would differ among drugs and

could be negative for some.

Estimated profits from drug development, averaged among all drugs and outpatient markets, would

Summary Table 1.

The Effect of the Administration's Proposal on the Present Value of

Profits Generated Over the Lifetime of the Average Drug

Change in Average Profits from

Developing a Drug (In percent)8

Administration's

Proposal

Universal

Coverage

Description

The proposal contains

a universal entitlement to a standard

benefit package that

includes prescription

drug coverage. Primarily affects the

under-65 population.

Effect on the

Presciption Drug

Market

Expenditures by

the under-65

population on all

Pharmaceuticals

would rise by 6

percent.

Drugs

Purchased

Only by

People

Under 65

8

Drugs

Purchased

Only by

People

65 and Over

0

Drugs Purchased

Two-Thirds by

People Under 65,

One-Third by

People 65 and Over

(Market average)b

6

Medicaid

Becomes Part

of the Alliance

System

Drug Benefit

Added to

Medicare

Government would

fully subsidize

participation of

most Medicaid

recipients in the

alliance system.

Medicare would

cover outpatient

drugs. A rebate

of at least 17 percent would be imposed on outpatient

drugs purchased

through Medicare.

Medicaid rebates

would be eliminated.

Average unit revenues

on outpatient sales

would rise by 2

percent.

Expenditures by the

65-and-over population

on outpatient pharmaceuticals would rise

by 4.5 percent. Unit

revenues would decline

by 17 percent.

Total 11

-17

•14

-6

SOURCE: Congressional Budget Office.

a. Change in the discounted value of the stream of profits generated by the worldwide sales of the average drug over its lifetime.

b. On average, people 65 and over account for 34 percent of prescription drug expenditures.
SUMMARY xv

rise modestly—by less than 3 percent—under the

Administration's proposal. Consequently, the level

of industry R&D might not change appreciably,

given the small changes in total returns from drug

development. (See Summary Table 1.)

Behind this average, however, market segments

would vary significantly. Profits would fall by an

average of 14 percent on those drugs that are sold

exclusively to the 65-and-over population and would

rise by 11 percent on those drugs sold exclusively

to the under-65 population. Although few drugs are

marketed exclusively to either population, CBO's

analysis found that under the Administration's proposal, once half of the market for a drug was made

up of sales to the 65-and-over population, returns

would decline slightly.

A decline in the profits from developing pharmaceuticals primarily for the 65-and-over market

would reduce the incentives to produce such drugs.

The difference in returns on the basis of age groups

might cause some R&D to be shifted away from

drugs targeted at those 65 and over toward drugs

aimed primarily at those under 65.

These estimates should not be viewed as CBO's

final analysis of the overall effects of the Administration's proposal. Rather, they are best viewed as

illustrative estimates of the portion of the proposal

that CBO was able to quantify. Although the factors omitted could serve to increase or decrease

returns, CBO's sensitivity analysis showed that large

variations in the assumptions about induced demand

do not change the overall result-namely, that the

proposal would affect average profits from drug

development only slightly.

CBO's calculations assume that the manufacturers entirely absorb the cost of the 17 percent Medicare rebate. Such burdens, however, are usually

shared between producers and consumers according

to their relative sensitivity to changes in price. But

because the Administration proposes to monitor

launch prices and price increases, pharmaceutical

companies might find it difficult to pass these rebates on to other consumers. Consequently, the

drug companies would probably absorb a very large

share of the rebate.

However, the more Medicare administrators are

able to make pharmaceutical producers absorb the

cost of the rebate, the less incentive these producers

will have to invest in developing new drugs for the

65-and-over market. By contrast, the less Medicare

administrators are able to make the pharmaceutical

companies absorb the rebate, the more other drug

consumers will pay for the Medicare benefits.

CBO's estimates assume that the federal government could enforce price restraints. But that is an

open question. Many times in the past the federal

government has tried to restrain price growth, usually with mixed results at best. The modern market

is too complicated for a limited bureaucracy to track

and control successfully. Prices in the drug market

are especially complicated; drug prices vary in

many dimensions (dosage, form, and packaging, to

name only three), any one of which could be used

to mask a price increase. Given the hundreds of

drugs and manufacturers and the thousands of dosage and packaging forms, the federal agencies in

charge of monitoring drug prices would have to rely

on the basic compliance of the drug companies, as

they do now for the Medicaid rebate. Such reliance

often leads to incomplete compliance.

Chapter One

Introduction

I

n many ways, the debate over the interaction

between health care reform and the pharmaceutical industry represents a more general

tension generated by changes in the health care

system and the development of new medical technologies. On the one hand, U.S. medicine is the

most technologically advanced in the world. The

public appreciates this and generally endorses the

continued development and provision of high-technology health care. On the other hand, many people feel that health care costs too much and that the

rapid pace of technological development is a major

contributing factor.

As proposals to restructure the health care system have proliferated, critics have expressed concern about the effects the proposed changes would

have on research and development (R&D) and future access to new treatments, including pharmaceuticals and other medical technologies. The quandary

facing health care reform efforts can be summed up

as a public desire to save the goose that laid the

golden eggs, but not to pay too much for the goose.

The desire for profits (or returns) is one of the

basic reasons that investors fund the R&D needed to

produce new pharmaceuticals and other medical

technology. The higher the anticipated returns from

technology development, the greater the incentive to

invest in the necessary R&D. If changes in the

health care system increase the profits from developing new medical technology, firms are likely to

increase their investment in it. Conversely, decreases in the returns from developing new medical

technology are likely to lower the level of R&D in

this field. Thus, reducing costs must be balanced

against affording sufficient incentive for drug companies and other providers of medical technology to

continue investing in medical progress.

The Administration's proposal, the Health Security Act, could change the returns from pharmaceutical R&D.1

 Although this study analyzes the effect

of the Administration's proposal on these returns,

many of its conclusions apply to other plans that

incorporate the same or similar features. Since

other health care proposals are trying to accomplish

similar goals, they face many of the same tensions

and are likely to use many of the same mechanisms.

Most reform proposals contain three elements

that would affect patterns of pharmaceutical use and

spending:

o Expanding coverage in the form of new benefits

and to new people,

o Shifting people into managed care, and

o Controlling costs.

What economists know about these elements is

very spotty. Surveys are available to help quantify

the effect of expanded coverage. Little information

exists, however, to help predict the effects of a

greater shift toward managed care plans or cost

control mechanisms on pharmaceutical spending.

References to the Administration's proposal are to the Health

Security Act, H.R. 3600 and S. 1757,103rd Congress, 1st Session,

1993. For a more comprehensive analysis of that proposal, see

Congressional Budget Office, An Analysis of the Administration's

Health Proposal (February 1994).
2 HOW HEALTH CARE REFORM AFFECTS PHARMACEUTICAL RESEARCH AND DEVELOPMENT June 1994

For example, the comparison of the use of pharmaceuticals in fee-for-service health plans with their

use in health maintenance organizations is based on

one limited study. The dual nature of pharmaceutical consumption~the fact that drugs complement

medical treatments as well as substitute for them—

also complicates the analysis. Thus, cutting down

health costs could lower pharmaceutical demand in

one way, but increase it in another.

The Administration's proposal also contains

provisions that may affect pharmaceutical demand

and are likely to interact with each other as well as

with the three elements above. A partial list includes:

o Outpatient prescription drug coverage for Medicare beneficiaries;

o Rebates on outpatient prescription drugs sold to

Medicare beneficiaries;

o Special Medicare rebates on new drugs and an

Advisory Council on Breakthrough Drugs to

examine launch prices;

o An end to rebates on outpatient prescription

drugs sold to Medicaid beneficiaries;

o Coverage of some services that are not well

covered now by private health plans and have

significant drug treatment components (examples include mental health and family planning

services);

o Coverage of investigational treatments (such as

some experimental drugs for human immunodeficiency virus—HIV—infection);

o Increased out-of-pocket costs for prescription

drugs for many current Medicaid beneficiaries;

and

o Constraints on the rate of growth of premiums

for the standard benefit package.

The combined effect of these provisions on

pharmaceutical demand and supply and on the future profitability of pharmaceutical R&D is highly

uncertain. The Congressional Budget Office (CBO)

cannot realistically provide a quantitative estimate

of all the effects of the Administration's proposal on

the pharmaceutical market. CBO's analysis examined the first four items on the list, in addition to

expanded coverage. In cases where estimates of the

quantitative effects could be made, CBO did so. In

other instances, the range of uncertainty was too

great and CBO made no estimate. Even when

quantitative information is available, it must be

applied with caution. In sum, the assessments discussed in this study are best considered illustrative

and partial estimates of the effects of the Administration's proposal for health care reform on the

profits from drug development.
Chapter Two

Industry and Market Background

T

he U.S. prescription drug market has grown

rapidly in recent years (see Figure 1). The

industry estimates that domestic prescription

drug sales, both institutional and outpatient, have

almost doubled since 1988, reaching an estimated

$58 billion in 1993.1 Since 1980, U.S. spending for

prescription drugs has grown at an average annual

rate of 13 percent. (These estimates are not adjusted for inflation. Many economists are concerned

about the accuracy of the Bureau of Labor Statistics' measures of price changes for Pharmaceuticals

(see Box 1). Instead of using them, this study presents pharmaceutical spending in relation to the

economy and the rest of the health care sector.)

Although spending on prescription drugs has

grown rapidly, it accounts for only a relatively

small portion of national health expenditures (see

Figure 2). Since 1972, prescription drug shipments

have accounted for between 4.5 percent and 6.5 percent of total national health expenditures. Indeed,

their share of national health expenditures has risen

by almost half since 1981. These figures represent

manufacturers' sales and do not reflect the final retail cost to consumers. The share of retail sales

would be higher, but this estimate reflects the share

of health expenditures that go to drug manufacturers.

This estimate excludes many over-the-counter drugs. Pharmaceutical Manufacturers Association, Trends in U.S. Pharmaceutical

Sales and R&D (Washington, D.C.: PMA, October 1993), p. 8.

Data for 1993 were revised by PMA in February 1994 and adjusted to reflect missing data. The Congressional Budget Office

obtained a similar estimate by adjusting data on industry shipments for over-the-counter drugs and net exports from the Census

of Manufacturers.

Prescription drug spending has doubled its share

of the gross domestic product (GDP) since 1972

(see Figure 3). In 1972, prescription drug shipments accounted for 0.4 percent of GDP. By 1993,

this share had risen to 0.8 percent of GDP.

This estimate differs from other analyses in that

it deals exclusively with prescription drugs. The

national health accounts gather into one category

Figure 1.

U.S. Prescription Drug Sales

Billions of Dollars

80

60

40

20

i i i i i i i i i i i i i i i i

1972

SOURCE:

1977 1982 1987 1992

Congressional Budget Office based on Pharmaceutical Manufacturers Association, Trends in U.S. Pharmaceutical Sales and R&D (Washington, D.C.:

PMA, October 1993), p. 8.

NOTE: Includes institutional and outpatient prescriptions. Estimate for 1993 was revised by PMA in 1994 and adjusted by the Congressional Budget Office to reflect

missing data.
4 HOW HEALTH CARE REFORM AFFECTS PHARMACEUTICAL RESEARCH AND DEVELOPMENT June 1994

Boxl.

Measurement Issues in Pharmaceutical Price Increases

By conventional measures, the pharmaceutical industry has consistently high inflation rates. But these

conventional measures are not well suited to industries, such as the pharmaceutical business, that frequently introduce new products.1

 The measures may

overstate the rate of increase in pharmaceutical

prices. In essence, conventional inflation gauges fail

to reckon with major forms of competition in the

pharmaceutical industry and therefore may not be

useful indicators of true inflation in the industry.

Measured by the producer price index (PPI),

increases in pharmaceutical prices have been dramatic. The PPI for pharmaceuticals doubled between 1982 and 1993, while the PPI for all finished

goods rose by only one-quarter. In other words, the

average annual increase in pharmaceutical prices (6.5

percent) was more than triple that for all finished

goods (2 percent).

Several economists have criticized the sample

used by the Bureau of Labor Statistics (BLS) to

measure pharmaceutical price increases in the PPI,

saying:

The number of drugs on the Department of Health and

Human Services list of existing drugs increased by 50 percent between 1982 and 1987. See David Cleeton, Valy

Goepfrich, and Burton Weisbrod, "What Does the Consumer

Price Index for Prescription Drugs Really Measure?" Health

Care Financing Review (Spring 1992), p. 45.

o The sample is too narrow,

o It is biased toward older drugs,

o It improperly incorporates generic drugs, and

o The measure excludes changes in quality.2

These critics argue that the relatively small

sample of drugs used by the BLS does not represent

the movements of the larger universe of drugs. In

one instance, the economists recalculated the degree

of pharmaceutical inflation using a larger sample

than that of the BLS and weighted the prices in a

way that more appropriately reflected the increasing

sales of new drugs. These two changes decreased

the measured inflation for the 1988-1991 period

from 8.4 percent as measured by the BLS to 6 percent with the corrected methodology and a larger

sample.3 (The PPI for all finished goods increased

at an annual rate of 4.1 percent during this period.)

Although the studies analyzed the PPI in detail, similar comments apply to the consumer price index (CPI) with some

modifications.

Ernst Berndt and Paul Greenberg, "Price Growth of Prescription Pharmaceutical Preparations: An Update and Explanation" (paper presented at the American Enterprise Institute

Conference on Competitive Strategies in the Pharmaceutical

Industry, Washington, D.C., October 27-28, 1993).

(drugs and medical nondurables) both prescription

drugs sold through retail outlets and other nondurable medical supplies, most notably over-the-counter

drugs. Most estimates of prescription drug spending

as a proportion of national health expenditures do

not separate these out. Conversely, the national

health accounts leave out of this category drugs that

are consumed in hospitals, nursing homes, and doctors' offices.

After the Food and Drug Administration (FDA)

approves a prescription drug, the drug's manufacturer often applies to have the product changed to

over-the-counter status to take advantage of consumer brand loyalty, especially when the patent is

nearing expiration.2 How the Administration's proposal would alter the incentives to change a drug's

status is beyond the scope of this study, which focuses on prescription drugs (see Figure 4 for a comparison of the U.S. over-the-counter and consumer

outpatient prescription drug markets).

Although federal statistical sources tally prescription drugs according to where they were purchased, these categories do not necessarily correspond to the reimbursement categories used by

Medicare, Medicaid, and private insurance compa-

"Self-Medication Boom," Med Ad News (February 1994), p. 44.

See also "Switches Don't Come Easy," Med Ad News (January

1994), p. 21.
CHAPTER TWO INDUSTRY AND MARKET BACKGROUND 5

The BLS agreed with the first two criticisms and

began to revise its pharmaceutical sampling methodology. The economists also argued that BLS methodology did not properly include generic drugs.

When the BLS includes generic drugs, it usually

classifies them as "new" drugs. Under most circumstances, the BLS does not link a name brand to its

generic replacement. Only when the brand-name

manufacturer of a particular drug also produces a

generic version of that drug is the connection sometimes made.

This lack of connection between brand-name and

generic versions of the same drug means that the

BLS inflation measure usually misses the price decline caused by movement to a cheaper generic drug.

For example, if a generic version costs 20 percent of

what the brand-name version costs, shifting 40 percent of quantities purchased to the generic form

would bring the average cost down by 32 percent.4

If each drug is classified as different, however, the

BLS will never measure a price drop. The BLS

may catch future changes in the price of the generic

drug, but a one-time shift to cheap sources would be

missed. In the market for one drug, cephalexin, the

conventional inflation measure showed a price rise

of 14 percent during the April 1987-September

1990 period, while one that included generic versions showed a drop of 48 percent.5

The BLS price measures also have no way of

incorporating the added benefit to consumers of better drugs; the prices of new drugs are not adjusted to

reflect additional therapeutic value. Recently, one

economist tried to make quality adjustments in one

product class (ulcer medicine) to see how much

prices had increased once the improvements were

factored in. She found that nominal price measures

had risen by 11 percent a year for the 1977-1989

period, but her quality-adjusted measure rose by only

6 percent a year for the same period.

Thus, two central policy goals for the pharmaceutical industry—controlling prices through new and

generic drugs and encouraging the development of

better drugs-are systematically mismeasured by both

the consumer price index and the PPL

4. Generic drug sales account for almost 40 percent of all drug

sales.

5. Zvi Griliches and Iain Cockburn, Generics and New Goods

in Pharmaceutical Price Indexes (Cambridge, Mass.: Harvard Institute of Economic Research, Harvard University,

December 1993).

6. Valerie Suslov, "Are There Better Ways to Spell Relief? A

Hedonic Pricing Analysis of Ulcer Drugs" (paper presented

at the American Enterprise Institute Conference on Competitive Strategies in the Pharmaceutical Industry, Washington, D.C., October 27-28, 1993).

nies.3 Most important, drugs purchased in nursing

homes are often classified as outpatient drugs for

the purposes of private insurance and Medicaid reimbursement. Some drug purchases in certain

skilled nursing facilities, however, are classified as

inpatient for the purposes of reimbursement by

Medicare, just as they would be in a hospital.

The Congressional Budget Office assumes that

if outpatient prescription drug benefits are extended

Office of Technology Assessment, Pharmaceutical R&D: Costs,

Risks and Rewards (February 1993), pp. 238-240.

to Medicare enrollees, most nursing home drug expenditures not now covered by Medicare would be

included. In 1991, nursing homes accounted for 3

percent of total U.S. pharmaceutical sales. Conversely, some drugs purchased in hospitals are for

outpatient use. In 1991, hospitals accounted for 23

percent of total U.S. pharmaceutical sales. CBO

assumes that these two sources of error in estimating the inpatient portion of the prescription drug

market will largely offset each other and that the

inpatient market is 23 percent of the total prescription drug market. CBO assumes the remainder is

the outpatient market.
6 HOW HEALTH CARE REFORM AFFECTS PHARMACEUTICAL RESEARCH AND DEVELOPMENT June 1994

Structure of the U.S.

Pharmaceutical Industry

The U.S. pharmaceutical industry is internationally

competitive and research-intensive. It produces

medicines for both human and veterinary use.

Within the human-use category, the industry includes companies that produce brand-name and

sometimes generic drugs; those that manufacture

brand-name drugs and products often related to

other aspects of medical care; and makers of generic

drugs, diagnostic substances, and bulk chemicals.

The industry is one of the most researchoriented in the United States. In 1991, it spent

almost three times as much on research and development (as a percentage of sales) as the average for

all U.S. manufacturers.4

Figure 2.

Prescription Drug Spending as a Percentage of

National Health Expenditures

Percent

6.5

6.0

5.5

5.0

4.5

4.0

i i i i i

1972

SOURCE:

1975 1978 1981 1984 1987 1990

Congressional Budget Office based on Pharmaceutical Manufacturers Association, Trends in U.S. Pharmaceutical Sales and R&D (Washington, D.C.:

PMA, October 1993), p. 8, and data from the Health

Care Financing Administration.

Figure 3.

Prescription Drug Spending as a Percentage of

Gross Domestic Product

Percent

1.0

0.8

0.6

0.4

0.2

o.o

1972

SOURCE:

1975 1978 1981 1984 1987 1990

Congressional Budget Office based on data from the

Bureau of Economic Analysis and Pharmaceutical

Manufacturers Association, Trends in U.S. Pharmaceutical Sales and R&D (Washington, D.C.: PMA,

October 1993), p. 8.

Competition and Barriers to

Entry in the Drug Industry

Manufacturers of the drugs that are most commonly

prescribed do not enjoy a monopoly. Instead, they

have competitors. In 1989, some 70 percent of prescriptions were written for multisource drugs, both

brand-name and generic.5 For the most part, these

are drugs for which the patent has expired and that

are now made by both generic and brand-name

companies. Alternatively, the drug might still be

under patent, but manufactured or marketed under

license by more than one company. Only 30 percent of prescriptions were for single-source drugs.

4. National Science Foundation, Selected Data on Research and

Development in Industry: 1991 (1993), Table SD-9. Industry

sources presented below differ.

5. Richard Caves, Michael Whinston, and Mark Hurwitz, "Patent

Expiration, Entry, and Competition in the U.S. Pharmaceutical

Industry," Brookings Papers on Economic Activity: Microeconomics, 1991 (1991), p. 6.
CHAPTER TWO INDUSTRY AND MARKET BACKGROUND 7

Figure 4.

U.S. Consumer Spending on Pharmaceuticals

40

30

20

10

Billions of Dollars

Outpatient

Prescription Drugs

V

Over-the-Counter Drugs

1960

SOURCE:

1970 1980 1990

Congressional Budget Office based on data from the

Bureau of Economic Analysis and the Health Gate

Financing Administration.

Just because a drug is made by only one company

does not mean that it has no competitors-often several different drugs will be available to treat the

same medical condition.6

Although much of the policy debate has been

focused on breakthrough drugs, the imitative drugs

also play a major role in the pharmaceutical market.

Imitative or "me-too" drugs use the same biological

mechanism as breakthrough drugs and can therefore

serve as alternative treatments. By providing therapeutic alternatives, these drugs can introduce competition into a market well before patents expire,

thus limiting the ability of the breakthrough-drug

manufacturers to sustain high prices. Me-too drugs

are often competing single-source drugs.

When Prozac was introduced into the antidepressant market in 1988, for example, it offered a

new treatment with fewer side effects than many of

6. A drug is considered multisource if bioequivalent versions are

available from more than one company. Other sources can be

brand-name or generic. If a drug is single source, it may have

close therapeutic substitutes, but not bioequivalent competitors.

Imitators (or "me-too" drugs) use different molecules to accomplish the same treatment as a single-source drugs. A generic drug

is certified by the FDA as being bioequivalent to the original drug

that has lost its patent.

the older antidepressants.7 The result was that Prozac became one of the five most widely prescribed

drugs in the United States, enjoying worldwide sales

of $1 billion in 1992.8 Such a market was a tempting target for other companies. Within five years,

three lower-priced drugs, all using some variant of

the same treatment, were on the market in the

United States. Four other drugs are being sold in

Europe and await FDA approval for U.S. sale. Because there are several close rivals, manufacturers of

antidepressant drugs are being forced to offer discounts, even though their patents last until after the

year 2000, when generic versions will be permitted

to enter the market.

One explanation for the rapid entry of rival

drugs into the market is that all were exploiting a

basic biomedical discovery and that the competing

companies had products already in the approval process when Prozac was sanctioned for sale. In many

instances, the first company to exploit a new biological discovery is merely the first among several to

complete a race to market. In some cases, however,

it is years before substitutes for truly innovative

drugs are introduced, although this is probably correlated with the size of the market they serve.9

The Prozac experience is not unique. According

to one recent study sponsored by the industry, in

therapeutic areas where treatments already existed,

new drugs introduced during 1991 and 1992 were

launched with prices that averaged 14 percent below

that of the market leader. New products in the most

active therapeutic categories averaged 36 percent

less.10 Another recent study of 148 drugs introduced into the U.S. market between 1978 and 1987

indicated that more than half of those substances

that provided the same benefits as existing drugs but

offered no increase in therapeutic potential were

7. Milt Freudenheim, "The Drug Makers are Listening to Prozac,"

New York Times, Business Section, January 9, 1994, p. 7.

8. "100 Powerhouse Drugs," Med Ad News Supplement (May 1993),

pp. S3, S7, and S14.

9. Z. John Lu and William S. Comanor, "Strategic Pricing of New

Pharmaceuticals" (paper presented to the American Economics

Association, Boston, Mass., January 1994).

10. Boston Consulting Group, The Changing Environment for U.S.

Pharmaceuticals (New York: Boston Consulting Group, April

1993), pp. 8-9.
8 HOW HEALTH CARE REFORM AFFECTS PHARMACEUTICAL RESEARCH AND DEVELOPMENT June 1994

introduced at prices below the market leaders.11 After drugs were launched at low prices, however,

price increases for many of them were higher than

average. (Drugs that provided new therapeutic capabilities were introduced at a premium.) But in

general the authors found, "both the introductory

price and subsequent price increases are lower

when there are more substitutes in the market."12

[Authors' emphasis.]

In some instances, when there are only one or

two imitators, competitive pressures may not be

substantial. Often several drugs will be appropriate

to treat a given condition, but will be imperfect substitutes. Each drug may have its particular strengths

and weaknesses, and often side effects. Thus, a

doctor may treat the same malady differently in different patients. Even when firms compete, they

may primarily use nonprice factors to do so. A

firm may, for example, increase its promotional efforts as a way of increasing market share. Price

competition is more likely to occur after several

rival manufacturers enter the scene. The fact that

some drugs may not have identical substitutes gives

the pharmaceutical companies some market power.

Although it is relatively easy to begin R&D in

the pharmaceutical industry, it is difficult to initiate

marketing. Some barriers are regulatory, such as

the seven- to eight-year process of getting a drug

approved by the FDA.13 Others are legal, such as

the monopoly provided by the patents on new medicines. Other barriers are economic, such as the

large research infrastructure necessary to produce

new and sophisticated chemicals that can compete

in the world marketplace.

There are many small firms in the industry, but

large firms play a disproportionate role in sales and

R&D. During the 1980s, the largest 20 companies

accounted for almost two-thirds of the pharmaceutical industry's total shipments.14

 But when only prescription drugs are counted, the top 20 firms account for more than 80 percent of the industry's

sales.15

In recent years, biotechnology firms have entered the industry in large numbers, but they have

yet to produce more than a handful of commercially

successful products. If new technology reduces the

cost of developing drugs, a substantial increase

should take place in the number and role of these

companies and their effect on prices and quantities

of drugs sold in the U.S. market. This change

would reduce some nonregulatory barriers to entry

into the industry.

Pharmaceutical Company Profits

High profits are commonly cited as proof of the

lack of competition in the pharmaceutical industry.

Although the industry does have high profit rates by

conventional measures (even accounting for higher

risk), such as the return on assets or return on

equity, these gauges are not well suited to such industries as the pharmaceutical business, which invests heavily in intangible capital, such as marketing

and R&D.16 These measures of profitability may

introduce a bias that results in an understatement of

a firm's capital assets, which in turn produces an

overstatement of its profit rate. In essence, conventional accounting measures of profit systematically

11. Lu and Comanor, "Strategic Pricing of New Pharmaceuticals."

12. Ibid., p. 26.

13. Joseph DiMasi and others, "Cost of Innovation in the Pharmaceutical Industry," Journal of Health Economics (1991), p. 123. See

also Office of Technology Assessment, Pharmaceutical R&D, p.

151.

14. International Trade Commission, Global Competitiveness of U.S.

Advanced-Technology Manufacturing Industries: Pharmaceuticals

(September 1991), p. 4-2. Shipments cover the received net selling values at the manufacturing plant of all product shipped.

15. Ernst Berndt and Paul Greenberg, "Price Growth of Prescription

Pharmaceutical Preparations: An Update and Explanation" (paper

presented at the American Enterprise Institute Conference on

Competitive Strategies in the Pharmaceutical Industry, Washington, D.C., October 27-28, 1993).

16. Most of the marketing expenses of the pharmaceutical industry are

not in advertising, but in promotional visits to doctors, usually

called detailing. In 1989, detailing accounted for three-quarters of

marketing expenses. Almost a quarter was devoted to advertising

in medical journals, with a small amount spent on direct mail

advertising. Caves, Whinston, and Hurwitz, "Patent Expiration,

Entry, and Competition in the U.S. Pharmaceutical Industry,"

p. 12.
CHAPTER TWO INDUSTRY AND MARKET BACKGROUND 9

ignore major forms of investment by the pharmaceutical industry and may therefore not be the most

appropriate measure by which to judge competition

in this industry.17 Economists have found that properly measured, pharmaceutical company profits are

only slightly above the average for companies in all

industries.

Conventional accounting rules permit firms to

accumulate certain types of spending as capital assets, but require other types to be deducted from

income in the year in which the expenditure is incurred. Expenditures for intangibles present special

problems. Clearly, in the right circumstances,

spending on marketing and R&D can benefit a company for years to come, just as it would benefit

from money spent on a manufacturing plant. In a

practical sense, such spending is an investment in

company assets. But conventional accounting practice does not classify it as such. Instead, accounting

practice treats it as a short-lived expense. Accounting measures of profitability are usually based on

the level of a firm's assets; expenses are deducted

from revenue to determine the profit level, which is

measured in relation to company gross or net assets.

Because industries vary in their level of R&D

and marketing, conventional accounting rules affect

their measures of profit differently. Firms in industries in which high levels of both R&D and marketing are important, such as the pharmaceutical industry, may find their asset-based measures of profit

systematically overstated. Conventional accounting

more accurately measures assets and profits in such

industries as heavy manufacturing in which neither

R&D nor marketing has played an important role.

Recently, Kenneth Clarkson, an economist specializing in the field of intangible assets, analyzed

the effects of conventional accounting rules on the

stated profit rates of 113 firms in 14 industries, including the pharmaceutical industry.18

 He found

that the rules distorted the measures of profitability

in many industries, in different directions, and to

different degrees.

First, Clarkson measured the importance of

intangible assets in the pharmaceutical industry.

Using income tax and census data, he found that

among the 14 groups examined, the pharmaceutical

industry was one of three that spent the greatest

proportion, as a share of net sales, on marketing.

Similarly, his measure of R&D showed the pharmaceutical industry to be third highest in spending

share. He split R&D into its components, on the

grounds that each would turn out marketable products at a different rate. Significantly, based on previous studies of the economic life of R&D, he argued that R&D in the pharmaceutical industry translates into products (accumulates) at between onehalf and three-quarters of the rate of other highR&D industries, partly because of lags in regulatory

approval. Slower accumulation would mean that

the R&D assets in the pharmaceutical industry are

lower than their high share of sales would imply.

Next, Clarkson recalculated the rates of return

on assets and equity (including the intangible assets)

for the firms in these industries during the 1980-

1989 period. He found that when he corrected for

differing rates of investment in intangible assets, the

average return on equity for all 113 firms fell

slightly, from 14 percent to 11 percent. By contrast, the pharmaceutical industry's rate of return on

equity fell from 21 percent to 13 percent. Although

still higher than in most industries (it ranked third

highest, after computer software and foods), the rate

of return in the pharmaceutical industry was much

closer to the mean—2 percentage points, not 7 percentage points, higher.

Clarkson's results are higher than, but generally

consistent with, earlier studies that attempted similar

adjustments. In general, the earlier studies found

that (1) the measured pharmaceutical industry profit

rate declined by between 2 percentage points and 6

percentage points when intangible capital was ad17. F. M. Scherer, "Pricing, Profits, and Technological Progress in the

Pharmaceutical Industry," Journal of Economic Perspectives

(Summer 1993), p. 104.

18. Kenneth Clarkson, "Intangible Capital and Profitability Measures:

Effects of Research and Promotion on Rates of Return" (paper

presented at the American Enterprise Institute Conference on

Competitive Strategies in the Pharmaceutical Industry, Washington, D.C., October 27-28, 1993).
10 HOW HEALTH CARE REFORM AFFECTS PHARMACEUTICAL RESEARCH AND DEVELOPMENT June 1994

justed for and (2) despite this, the industry profit

rate remained above the average by 3 percentage

points. The Office of Technology Assessment

(OTA) also sponsored an independent study of the

pharmaceutical industry's profitability, using a different methodology. This study's conclusions are

similar to Clarkson's.19

Thus, differing pictures of the pharmaceutical

industry emerge, depending on the measures of

profitability applied. The more conventional measures point to a very profitable industry in which

monopoly profits generated by patents raise the industry return to very high levels. A more sophisticated look—one that more nearly matches the industry investment profile-shows a less but still

quite profitable industry, but one in which R&D

spending and patent rights generate imperfect competition rather than monopoly. This latter picture is

consistent with the analysis presented later in this

report, which shows that the average new drug produces a small amount of excess profits; that is,

profits beyond those necessary to reward the investors after manufacturing and other costs have been

paid. These excess profits also help explain why

drug companies may have increased their R&D dramatically during the 1980s and why more firms are

seeking to enter the market.

The Role of R&D in the

Pharmaceutical Industry

The U.S. pharmaceutical industry has always invested heavily in R&D. The process starts in the

laboratory with the discovery of chemicals and

19. See Office of Technology Assessment, Pharmaceutical R&D,

pp. 96-99. In fairness, Clarkson's sample of companies is the

broadest, both within the pharmaceutical industry and generally, of

any study reviewed by OTA. See William Baber and Sok-Hyon

Kang, "Accounting-based Measures as Estimates of Economic

Rates of Return: The Case of the U.S. Pharmaceutical Industry,

1976-1987" (paper produced under contract with the Office of

Technology Assessment, July 1991).

Some people have argued that pharmaceutical companies have

greater profits, but that they dissipate these profits in R&D races

or by paying too much for the R&D they undertake. One study

examined by CBO suggested that fears about R&D races were

overstated. See Rebecca Henderson and Iain Cockburn, "Racing

to Invest? The Dynamics of Competition in Ethical Drug Discovery" (Sloan School of Management, Massachusetts Institute of

Technology, Cambridge, Mass., May 1993).

Figure 5.

Research and Development Spending by the U.S.

Pharmaceutical Industry (In billions of dollars)

Billions of Dollars

12

10

8

6

4

1970

SOURCE:

1975 1980 1985 1990

Congressional Budget Office based on Pharmaceutical Manufacturers Association, Trends in U.S. Pharmaceutical Sales and R&D (Washington, D.C.:

PMA, October 1993), p. 6.

molecules that have therapeutic potential, turns these

substances into products, and culminates in testing

on animals. Industry R&D then moves to clinical

trials, where first safety, then efficacy, of the products are tested in three phases on ever-increasing

numbers of people. Long-term animal trials typically continue during the human clinical trials.

Drugs that fail one step typically do not proceed to

the next.

Industry research and development (both foreign

and domestic) has increased continuously for the

last two decades, both in absolute terms and as a

percentage of sales (see Figures 5 and 6).20 At least

part of the increase in R&D is the result of rising

costs of clinical trials.21 Half of the industry R&D

20. Pharmaceutical Manufacturers Association, Trends in U.S. Pharmaceutical Sales & R&D, pp. 4-8, and National Science Foundation, Selected Data on Research and Development in Industry:

1991. Both sources agree roughly on patterns and trends in R&D

spending. There is a 15 percent discrepancy between the different

sources. The industry and NSF also have different classifications

for industry sales so their R&D-to-sales ratios differ.

21. Measured by number of clinical trials or patients per drug approval. Some analysts argue that these costs are rising because

the pharmaceutical industry is now grappling with more long-term

and complicated illnesses that do not lend themselves to straight-
CHAPTER TWO INDUSTRY AND MARKET BACKGROUND 11

Figure 6.

Research and Development Spending

by the U.S. Pharmaceutical Industry

(As a percentage of sales)

20

18

16

14

12

Percent

10

1970 1975 1980 1985 1990

SOURCE: Congressional Budget Office based on Pharmaceutical Manufacturers Association, Trends in U.S. Pharmaceutical Sales and R&D (Washington, D.C.:

PMA, October1993), p. 7.

expenses occur once clinical trials have begun.22

Furthermore, the share of trial-related expenses has

been rising over the last decade.

Although the federal government spends heavily

on biomedical research, it spends relatively little

directly on drug development. Overall, federal

agencies spent $750 million in clinical and preclinical pharmaceutical evaluations in 1990.23

 By comparison, the U.S. drug industry spent $10.8 billion

worldwide on pharmaceutical R&D for human use

in 1992.24

forward analysis. Boston Consulting Group, The Changing Environment for U.S. Pharmaceuticals, pp. 25-32. OTA also finds that

the size of clinical trials is rising. Office of Technology Assessment, Pharmaceutical R&D, pp. 64-65.

22. Pharmaceutical Manufacturers Association, Trends in U.S. Pharmaceutical Sales & R&D, p. 29.

23. Office of Technology Assessment, Pharmaceutical R&D, pp. 214-

215 and 311-315.

24. Pharmaceutical Manufacturers Association, Trends in U.S. Pharmaceutical Sales & R&D, p. 26.

R&D and the Industry Cost Structure. It is well

known that researchers in the pharmaceutical industry typically test thousands of chemicals in order to

find one that passes all the clinical trials and is finally approved by the FDA. It is less well known

that, on average, only 3 of 10 drugs approved by

the FDA and brought to market sell sufficiently well

to earn back the average investment in R&D for a

new drug, which includes the cost of the pharmaceuticals that do not even make it to market.25

 Of

these three, in the recent past, only one has been a

principal source of industry income. Thus, a few

very successful discoveries provide most of the income (see Figure 7).

As a share of sales price, pharmaceutical production costs are low; the Office of Technology Assessment estimates that the share is 25 percent.26

One implication of this cost structure (high sunk

costs, low production costs) is that a larger pharmaceutical market (in terms of quantity) permits lower

prices because it allows the sunk costs, or money

that has already been committed and spent for R&D

costs, to be spread over a larger number of buyers.

For drugs marketed during the early 1980s, these

R&D costs, including funds spent during FDA clinical trials, averaged close to $200 million per drug.27

Such costs are considered to be largely fixed, or

constant, because the R&D is the same whether the

company sells one or one billion pills.28

25. Henry Grabowski and John Vernon, "A New Look at the Risks

and Returns to Pharmaceutical R&D," Management Science (July

1990), p. 816. Analysts lack published data on costs by project;

only the average cost is available. Thus, a drug might still be

profitable even if sales do not cover the average amount spent on

R&D, but it is unlikely to be very profitable unless its R&D costs

are also very low.

26. Office of Technology Assessment, Pharmaceutical R&D, p. 91.

This 25 percent includes plant depreciation. Pure variable costs

account for an estimated 17 percent to 21 percent of price. See

the discussion of the rate of return calculations below.

27. These costs are capitalized-that is, they included the time value of

money. Office of Technology Assessment, Pharmaceutical R&D,

pp. 47-72.

28. There is some post-launch R&D-in enhancing production, for

example—that can be varied, especially during the early years of

the market. Obviously, there is R&D to sell improved versions of

a product. But since the improved version also has to be approved by the FDA, this analysis is considering it as a new product. In addition, the marketing costs can largely be considered

fixed.
12 HOW HEALTH CARE REFORM AFFECTS PHARMACEUTICAL RESEARCH AND DEVELOPMENT June 1994

Figure 7.

Sales of Ten Companies' Top Three Drugs as a Percentage of Prescription Sales by Each Firm

Glaxo Inc.

Pfizer

Upjohn

Eli Lilly

SmithKline Beecham

Merck & Co.

Marion Merrell Dow

American Home Products

Johnson & Johnson

Bristol-Myers Squibb

--rv C-;

.%., , .y -TM S STM^. ^./ • ^" ^ ' "=TV« J

"" J ^"V>"' J

ks>'s -^-- vo^a* ; -

s

 v

20 40 60 80

SOURCE: Congressional Budget Office based on Boston Consulting Group, The Changing Environment for U.S. Pharmaceuticals (New

York: Boston Consulting Group, April 1993), p. 41.

Consequently, it is often profitable for pharmaceutical companies to sell drugs at deep discounts as

long as the price is above the low cost of production. The high level of fixed costs also helps to

explain why pharmaceutical companies try to market their drugs worldwide, even in countries that

control prices; every foreign sale, even at a low

price, helps to pay not only for the low production

cost but also for the single large R&D investment.

The fact that pharmaceutical companies can offer

some consumers prices that they do not offer to others also encourages discounting.

R&D and International Competition. U.S. pharmaceutical companies are highly competitive in the

international marketplace. The strength of the U.S.

industry lies in its large R&D infrastructure and

ability to produce new products of high quality.

According to one recent survey, U.S. companies

developed 113 of the 265 major globally prescribed

drugs that were developed between January 1970

and May 1992.29 U.S. companies develop a smaller share of all drugs, but produce almost half of all

new drugs sold in all major markets. This technological success (and the R&D that precedes it) is

not concentrated in a few therapeutic categories,

such as anti-infective and cardiovascular drugs, but

occurs in most major therapeutic categories.

In 1990, nine of the largest twenty pharmaceutical firms in the world were based in the Xlnited

States.30 According to the Department of Commerce, U.S. firms accounted for almost half of the

world's pharmaceutical sales on a value basis. And

the industry runs a positive balance of trade (that is,

exports exceed imports). Most of the U.S. pharmaceutical exports went to Organisation for Economic

Cooperation and Development (OECD) countries.

Almost half of U.S. exports went to the European

Community, which has several nations with strong

pharmaceutical industries.31

30. International Trade Commission, Global Competitiveness of U.S.

Advanced-Technology Manufacturing Industries: Pharmaceuticals,

p. 4-2.

29. Heinz Redwood, "New Drugs in the World Market," The American Enterprise (August 1993), pp. 72-80.

31. Department of Commerce, U.S. Industrial Outlook 1994 (January

1994), p. 43-2.
CHAPTER TWO INDUSTRY AND MARKET BACKGROUND 13

The U.S. market accounts for one-third of world

pharmaceutical sales.32 Not all countries consume

the same drugs, however. Many drugs are local,

sold in protected or specialized markets. Global

drugs are those that are sold in all or most major

markets. The U.S. market for global drugs accounts

for an even larger fraction of world sales for these

drugs. Global drugs are usually considered more

technologically advanced. Because the U.S. market

possesses such a large fraction of the total sales of

these drugs, U.S. health policy may have a disproportionate impact on the development of pharmaceuticals throughout the world. Alternatively, sales

abroad represent more than half of the market for

drugs patented in the United States and will therefore not be affected by health care reform.

Competition in the U.S.

Pharmaceutical Market

The U.S. pharmaceutical market has major structural

features on both the supply and demand sides that

impede the functioning of a perfectly competitive

market. These factors have served partially to shelter firms in the industry from competition, as the

profit figures discussed above suggest. But changes

are taking place in the market, independent of proposed federal policy changes, that are lowering

some of these impediments to competition.

Consumers' Insensitivity to Cost

One factor that exacerbates the imperfect competition is the presence of doctors in the decisionmaking process. Doctors are relatively cost-insensitive in prescribing medicine, for which they do not

pay. A doctor's objective is to treat the patient and

not necessarily to provide the most cost-effective

treatment.33 Since prescription drugs typically constitute, in nonchronic cases, only a small fraction of

the total cost of treating the patient, the doctor's

incentive to examine drug costs declines even more.

Moreover, because the consumer often cedes large

parts of his or her decisionmaking power to a physician or other medical expert—and indeed is often not

in a position to judge the medical cost-benefit tradeoffs—the usual cost-controlling mechanisms of the

marketplace become less effective. The substitution

of generic drugs, which is at the patient's choice in

most states, is the major—and relatively recent-exception to the medical consumer's usual attitude

toward costs.

Nor is judging the cost-effectiveness of treatment straightforward: different patients might value

the same costs differently. Some patients might

prefer more effective treatment at a higher cost,

while others might be willing to incur some risk to

save some money. Doctors, fearing malpractice

suits or perhaps a negative reputation based on

unsuccessful treatment, might also value the tradeoff between costs and risks differently.

Another element of the U.S. pharmaceutical

market that serves to make demand less sensitive to

price is the widespread coverage of pharmaceuticals

by insurance and other third-party payers. Although

only one-quarter of outpatient pharmaceutical expenditures were covered by insurance in 1977, by

1987 more than 40 percent of all outpatient prescription drug expenditures were covered by thirdparty payers.34

 Because patients are often reimbursed or because they only pay a small flat fee per

prescription, they do not respond as much to costs

as they would if they were bearing the full expense.

The presence of these cost-desensitizing factors,

however, does not mean that consumers ignore

price, just that they are less aware of it than they

otherwise might be. Many consumers have large

deductibles as well as coinsurance or copayments in

their pharmaceutical coverage, making them more

sensitive to cost. The result is that consumers bear

a much higher share of the expenditures for prescription drugs than they do for physician or hospital services. In 1991, consumers paid out of pocket

for 55 percent of prescription drug expenditures, 18

percent of physician services, and 3 percent of hos32. "Single Digit Growth for World Pharma [sic] Market," Scrip Magazine (January 1994), p. 32.

33. Doctors in managed health care provider groups may face different incentives.

34. Office of Technology Assessment, Pharmaceutical R&D, p. 239.
14 HOW HEALTH CARE REFORM AFFECTS PHARMACEUTICAL RESEARCH AND DEVELOPMENT June 1994

pital services.35 And, as noted above, generic substitution is available in most states.

Changing Factors in the Market

The behavior of consumers and third-party payers is

changing. Third-party payers are increasing the

share of total prescription costs that they pay, but

also increasingly trying to rein in their costs. In

addition, consumers are increasing their use of generic substitutes.

Pharmaceutical Benefit Management. The desire

to control pharmaceutical costs has generated a

growing number of companies devoted to managing

pharmaceutical benefits for unions, insurance companies, and large corporations. The net effect of

their efforts is to reduce pharmaceutical costs to the

consumer through increased use of generic drugs

and other techniques. (Managed care providers also

perform many of these cost-reducing functions within their organizations.)

In a sense, these benefit-management companies

act as agents of the pharmaceutical-purchasing public. They buy generic drugs where and when they

can. When generic drugs are not available, they use

buying power to get a good price, especially when

imitative drugs are available. In economic terms,

these techniques make demand for the products of

any drug manufacturer more elastic-that is, more

price sensitive—for whole segments of the population. This greater price sensitivity lowers the market power of a drug manufacturing firm by reducing

its ability to price its products above the unit cost,

which would be the price in a purely competitive

industry.

In order to wield this buying power, a benefitmanagement firm has to press purchasing discipline

on doctors and patients. It can negotiate a significantly better price with a drug company only if it

can ensure that its members will only buy specific

drugs. Among the tools at its disposal are approved

drug lists (often called formularies) and even electronic point-of-sale technology, so that the pharmacist can intervene to persuade doctor and patient to

use listed drugs. Similarly, organizations that manage prescription benefits can vary drug reimbursement for the patient according to the formulary: a high percentage for drugs on the formulary,

a low percentage for drugs not on it. According to

some industry estimates, the majority of people who

have pharmaceutical benefits either have such restrictions on their benefits or will soon have them.

Even now, those companies that choose to can

enforce their restrictions in order to get the discounts. Kaiser Permanente, the largest health maintenance organization in the United States, for instance, distributes its formulary to its doctors, tracks

their prescribing behavior, restricts access to them

by representatives of pharmaceutical companies, and

provides information to them concerning the reasons

that certain drugs are on the formulary. Consequently, as of May 1993, 96 percent of Kaiser's

prescriptions were from the formulary and 75 percent of the prescriptions were for generic drugs.36

In general, however, it is difficult to estimate

how much consumers and third-party payers truly

have exercised buying power to reduce pharmaceutical costs. Although the trend seems to be definitely

in the direction of managing pharmaceutical benefits, the actual carrying out of the demand management techniques may still be sparse and uneven.

For example, a recent study in the Journal of the

American Medical Association suggests that marketing by pharmaceutical companies can influence the

inclusion of drugs on formularies, even when there

is little, if any, therapeutic advantage.37 The study

showed that doctors are still able to choose the

drugs they deem necessary for treating hospital patients, despite the attempts of hospital administrators

to limit pharmaceutical spending through approved

drug lists, and that doctors' decisions are substantially influenced by direct contact with pharmaceutical companies.

35. Congressional Budget Office, Trends in Health Spending: An

Update (June 1993), pp. 56, 60, 66.

36. Sylvia Morrison, "Prescription Drug Prices: The Effect of

Generics, Formularies and Other Market Changes" (Congressional

Research Service, August 17, 1993).

37. About half of the doctors' requests for addition were for drugs

with some therapeutic advantage. Mary-Margaret Chren and C.

Seth Landefeld, "Physicians' Behavior and their Interactions with

Drug Companies," Journal of the American Medical Association

(March 2, 1994), pp. 684-689.
CHAPTER TWO INDUSTRY AND MARKET BACKGROUND 15

The definitions of managed care are also murky.

Some traditional fee-for-service health plans have

managed drug benefits. Even when drug benefits

are managed, it does not necessarily mean that the

plan is exercising substantial market power on behalf of consumers. For instance, although Merck

recently reported that fully half of its sales come

from managed care plans and that the company

expects this share to rise, the firm's definition of a

managed care plan is unclear.38

One factor limiting the further penetration of

formularies is the lack of reliable studies of costeffectiveness. The group with the largest individual

incentive to undertake such studies, the pharmaceutical companies, is limited by FDA regulations that

require its promotional claims to be backed by highquality university studies, which are time-consuming

and expensive.39 The FDA must approve the

claims, a process that also takes time. All users,

including their agents in the health plans, may have

sufficient economic incentive to explore the costeffectiveness of medical procedures and drugs, but

they cannot do it individually. Thus, such research,

although growing rapidly, is still in its infancy.

Increasing Use of Generic Drugs. Another growing force in the U.S. pharmaceutical industry is the

increasing penetration of the market by generic

drugs. Under the Drug Price Competition and Patent Term Restoration Act of 1984, the Congress and

the Reagan Administration chose to make generic

drugs the principal cost containment vehicle in the

pharmaceutical market by establishing a shorter process of regulatory approval for generic drugs. Consequently, the market share of generic drugs has

been increasing. In 1980, generic drugs accounted

for 23.3 percent (in units) of all pharmaceuticals

sold in the United States.40 By 1991, generic drugs

accounted for a much higher share of the units sold

38. Michael Waldholz, "Pharmaceutical Firms' Profits Rise Expected

to be Slim," The Wall Street Journal, January 18, 1994, p. B12.

39. For one proposal, see John Calfee, "The Leverage Principle in

FDA Regulation of Information" (paper presented at the American

Enterprise Institute Conference on Competitive Strategies in the

Pharmaceutical Industry, Washington, D.C., October 27-28, 1993).

40. Alison Masson and Robert Steiner, Generic Substitution and Prescription Drug Prices: Economic Effects of State Drug Product

Selection Laws (Federal Trade Commission, 1985), p. 1113.

—almost 40 percent, according to one estimate.41

(In terms of value, generic drugs represented 13

percent of U.S. sales in 1989.)42

The existing group of generic drugs is large and

should grow further over the next several years because many brand-name pharmaceuticals will be

losing their patent protection. Drugs losing their

patents between 1992 and 2000 include 54 of the

100 most popular drugs and account for an approximately equal share of such sales. Furthermore, only

one of the 10 most widely used drugs will not lose

its patent between now and 2000. That drug is

Zantac, and although it is not losing its patent, its

closest competitor, Tagamet, did this year.43 Because of the number of important drugs that will

lose their patents during the early 1990s, the revenue share filled by generic drugs is expected to rise

to more than one-quarter of the market by the middle of this decade.44

The market-based movement towards generic

drugs is likely to lower the profitability of investment in R&D less than regulatory or governmentbased attempts at cost containment. One reason is

that generic versions of a pharmaceutical product

come at the end of its patent life, which means that

the present value of the lost sales is lower than if

the generics could compete right away. By contrast,

rebates, such as those currently given drugs paid for

by Medicaid and proposed by the Administration for

Medicare, are given from the date of introduction of

a new drug and have a higher present value. Thus,

an immediate rebate is likely to have a larger effect

on the expected profitability of a drug than will its

eventual displacement by generic equivalents. Similarly, other aspects of the Administration's proposal

41. Morrison, "Prescription Drug Prices," p. 1.

42. International Trade Commission, Global Competitiveness of U.S.

Advanced-Technology Manufacturing Industries: Pharmaceuticals,

pp. 4-3 and 4-4.

43. "100 Powerhouse Drugs," Med Ad News Supplement (May 1993),

pp. S5 and S30. In addition, there is a lawsuit regarding the status

of the patent on Zantac.

44. International Trade Commission, Global Competitiveness of U.S.

Advanced-Technology Manufacturing Industries: Pharmaceuticals,

pp. 4-3 and 4-4.
16 HOW HEALTH CARE REFORM AFFECTS PHARMACEUTICAL RESEARCH AND DEVELOPMENT June 1994

that have an immediate impact on a drug's price probably best be described as imperfectly competiwould be more likely to affect the profit on invest- tive: firms have some power to raise prices and genment in R&D than would competition from a erate excess profits. But events in the pharmaceutigeneric. cal market—including growth in generic drug use

and more use of collective buying strength on the

part of third-party payers—are beginning to undermine this power and make the industry more competitive.

In the continuum between a perfect monopoly and

perfect competition, the pharmaceutical industry can
Chapter Three

How the Administration's Proposal

Would Affect the Demand

for Prescription Drugs

O

f all the features of the Administration's

proposed health care plan, universal coverage would have the greatest impact on the

demand for prescription drugs. If it were enacted,

this provision would extend a comprehensive package of health benefits, including coverage of prescription drugs, to the entire under-65 population,

including 37 million people who are currently uninsured. The Administration's proposal for health

care reform would also add a new drug benefit to

Medicare, which is now the primary source of

health insurance coverage for the 65-and-older population. Just under one-half of the 65-and-over

population would receive drug coverage for the first

time.

The Congressional Budget Office estimates that

a universal entitlement to the standard benefit package in the Administration's proposal would increase

spending on all prescription drugs by approximately

3 percent to 5 percent.1 The proposed Medicare

drug benefit would increase spending on all prescription drugs by an additional 1 percent. A high

level of uncertainty underlies these estimates of

what economists call induced demand.

CBO's estimates do not consider the effect that

a greater shift to managed care plans might have on

prescription drug expenditures. Prescription drug

expenditures in managed care plans might be higher

or lower than those in fee-for-service plans. Managed care plans might substitute prescription drugs

for more expensive forms of treatment, thereby increasing prescription drug expenditures. But managed care plans might also exercise greater control

over prescriptions, using generic drugs more intensively than fee-for-service plans, a policy that could

lower prescription drug expenditures. CBO has not

attempted to quantify these possible effects.

CBO's induced demand estimates are based on

expenditures for outpatient prescription drugs reported in the 1987 National Medical Expenditure

Survey.2 These expenditures were not inflated to

1994 dollars because the induced demand estimates

were based on the percentage of difference in average expenditures among groups. The estimates

were calculated using the average percentage of difference in outpatient drug expenditures among people with different types of health coverage. These

average expenditures have been adjusted for differences in population characteristics, specifically those

according to health status, age, family income, sex,

race and ethnicity, marital status, education, employment status, and region of residence. Underreporting is a problem in this survey, but does not

affect CBO's analysis insofar as it is evenly spread

among subgroups.

It is the combination of a universal entitlement with a generous

benefit package (offering both comprehensive physician and drug

coverage) that leads to CBO's estimate of induced demand. For

the sake of brevity, this will be referred to as the universal coverage provision of the Administration's proposal.

2. This is a representative survey of the noninstitutionalized population in the United States. The tabulated results for prescription

drug expenditures for 65-and-over Medicare enrollees were reported in the Congressional Budget Office study, Updated Estimates of Medicare's Catastrophic Drug Insurance Program (October 1989).
18 HOW HEALTH CARE REFORM AFFECTS PHARMACEUTICAL RESEARCH AND DEVELOPMENT June 1994

The Administration's

Proposal for Universal

Coverage

The extension of health coverage to all U.S. residents primarily affects the under-65 population because Medicare already covers 98 percent of the 65-

and-over population.3 Almost all uninsured U.S.

residents are under age 65. CBO projects that the

universal coverage component of the Administration's proposal (which includes a drug benefit)

would increase the expenditures for prescription

drugs by the under-65 population by 5 percent to 7

percent. Most of the increase would result from

extending coverage to those who are currently uninsured and only a small fraction from currently insured people who would be receiving better drug

benefits under the proposed standard benefit package. The increase would occur mostly in outpatient

rather than inpatient prescription drugs. The under65 population accounts for about two-thirds of all

prescription drug expenditures.4 Universal coverage

would therefore increase total prescription drug expenditures by an estimated 3 percent to 5 percent.

Proposed Coverage

Under the Administration's proposal, the under-65

population would be covered by one of three basic

plans, each of which would include coverage for

both physician visits and outpatient prescription

drugs. Much of the under-65 population already

has employment-based physician and drug coverage

that is similar to the coverage in the Administration's proposal.

The three basic types of plan included in the

Administration's proposal are:

4.

Health Care Financing Administration, Medicare and Medicaid

Statistical Supplement (1992), p. 14. Table 1 reports a lower

number (96 percent) because it includes only those who obtain

their primary coverage through Medicare.

Office of Technology Assessment, Pharmaceutical R&D: Costs,

Risks and Rewards (February 1993), p. 239.

o A lower-cost-sharing plan that would employ a

network of providers and require small copayments for most services;

o A higher-cost-sharing plan, under which patients

would choose their providers, meet a deductible

before coverage begins, and pay a coinsurance

rate thereafter; and

o A combination plan under which patients would

pay the lower-cost-sharing rates only if they use

network providers, but would pay the highercost-sharing rates if they do not.

The lower-cost-sharing plan would require a $5

copayment for prescriptions and a $10 copayment

for physician visits. The higher-cost-sharing plan

would require that patients spend $300 on health

services before physician coverage begins and $250

on prescription drugs before that coverage begins.

A coinsurance rate of 20 percent would apply thereafter to most expenditures. One important advantage of the lower-cost-sharing plan would be that it

has no deductibles. Each plan would limit annual

out-of-pocket expenditures to $1,500 for individuals

and $3,000 for families.

CBO did not determine which of the three kinds

of plans would attract the most enrollees. The

outcome would depend on how the public perceives

differences in quality of care and how premiums

vary among plan types (and within each regional

alliance). CBO did not estimate how prescription

drug expenditures would differ between the lowerand higher-cost-sharing plans. CBO's calculation of

induced demand does not address the differences in

coverage among the three kinds of plans.

Drug expenditures could be higher under the

lower-cost-sharing plan for two reasons. First, the

lower-cost-sharing plan would have no deductibles.

In other words, coverage would begin with the

enrollee's first physician visit and first prescription.

Since the consumption of prescription drugs is

closely associated with physician visits, this kind of

coverage would tend to increase drug expenditures.5

It is possible for those enrolled in fee-for-service plans to purchase

supplemental coverage for cost sharing, in which case initial coverage would be as good as in the lower-cost-sharing plan.
CHAPTER THREE EFFECT ON THE DEMAND FOR PRESCRIPTION DRUGS 19

Second, the lower-cost-sharing plan is likely to be a

managed care plan such as a health maintenance organization (HMO), which may use prescription

drugs more intensively. Nevertheless, drug expenditures in the lower-cost-sharing plan could be lower

if it exercises greater control over prescription

choice.

Employment-Based Coverage

According to the 1990 Current Population Survey,

two-thirds of the population under age 65 obtain

their primary health insurance coverage through

their employers. The Administration's proposal for

comprehensive coverage is roughly equivalent to

that of many employment-based plans. This similarity implies that the prescription drug expenditures

of people who are insured through their employers

would not increase because their coverage would

not change appreciably.

Employees who are now insured through firms

employing more than 100 workers have coverage

that is, for the most part, at least as good as that

proposed in the higher-cost-sharing plan. According

to a recent Bureau of Labor Statistics (BLS) publication that examines the health insurance benefits in

firms employing 100 or more workers, 83 percent

of full-time employees are covered by health insurance. Of those covered, two-thirds are in fee-forservice plans, 16 percent are in preferred provider

organizations, and 15 percent are in HMOs. The

average deductible is $198 and only 6 percent of

those insured have a deductible of $300 or more.6

The most common coinsurance rate is 20 percent,

and all but 12 percent of those insured through a

large employer have a coinsurance rate of 20 percent or less. Only 4 percent of people insured by

these firms do not have outpatient prescription drug

coverage. The fee-for-service plans typically do not

have a separate deductible for prescription drugs,

which means that their drug coverage is usually

slightly better than the proposal's higher-costsharing plan.7

 Apparently, deductible and copayment policies covering drugs and physician visits

are slightly more generous under the employmentbased plans than they would be under the highercost-sharing plan proposed by the Administration,

but are not usually as generous as the lower-costsharing plan.

Coverage is similar for people who are insured

through firms that employ fewer than 100 workers.

According to another BLS survey, although a lower

proportion of full-time workers in these establishments have coverage through their employers (69

percent), people who are covered often have benefits similar to those of employees in larger companies. The average deductible is $197 and coinsurance rates of 20 percent are common. All but 3

percent of those insured have prescription drug coverage.8

 People who are insured through their employers would therefore probably not increase their

prescription drug expenditures because their current

coverage is usually about as good as that proposed

by the Administration.

Outpatient Drug Demand and the

Uninsured Under-65 Population

Increased demand for prescription drugs would result largely from extending coverage to the 17 percent of the population under age 65, or 37 million

people, who have no health insurance (see Table 1).

Those whose physician coverage would improve

under the Administration's proposal or who currently do not have outpatient drug coverage would

also increase their demand for prescription drugs.

This outcome may apply to that portion of the population (7 percent) who are covered by policies that

are privately purchased. The remaining three-quarters of the under-65 population already have physician and drug coverage through their employers or

Medicaid that is for the most part as generous as

that in the proposal's higher-cost-sharing plan. (The

drug coverage currently provided by Medicaid typically has lower cost-sharing requirements than that

proposed by the Administration.)

6. Bureau of Labor Statistics, Employee Benefits in Medium and

Large Private Establishments, 1991 (May 1993).

7. Cathy Baker and Natalie Kramer, "Employer-Sponsored Prescription Drug Benefits," Monthly Labor Review (February 1991),

states that fee-for-service plans generally do not have a separate

drug deductible, based on the Bureau of Labor Statistics results.

8. Bureau of Labor Statistics, Employee Benefits in Small Private

Establishments, 1990 (September 1991).
20 HOW HEALTH CARE REFORM AFFECTS PHARMACEUTICAL RESEARCH AND DEVELOPMENT June 1994

The amount by which prescription drug expenditures would rise if coverage were extended to the

uninsured can be estimated using the outpatient prescription drug expenditures reported in the 1987

National Medical Expenditure Survey (NMES).

According to this survey, average outpatient prescription drug expenditures for an uninsured person

under 65 were about $35 in 1987. After adjusting

for differences in population characteristics between

the uninsured and those with employment-based

coverage, CBO estimates that the uninsured underTable 1.

Primary Source of Health Insurance for the U.S.

Noninstitutionalized Population, by Age, 1993

Source of Insurance Total

Under

65

65 and

Over

Population in Millions

Employment-Based

Medicare

Medicaid

Department of

Veterans Affairs5

Other Private

None

Total

147.8

32.5

20.5

0.8

15.1

37.4

254.2

146.4

3.6

20.5

0.8

15.0

37.1

223.4

Percentage of Age Group

Employment-Based 58 66

Medicare 13 2

Medicaid 8 9

Department of

Veterans Affairs6 c c

Other Private 6 7

None 15 17

Total 100 100

1.4

28.9

a

a

0.1

0.4

30.8

5

94

c

c

c

1

100

SOURCE: Congressional Budget Office tabulation of March

1993 Current Population Survey.

a. Less than 25,000.

b. Civilian Health and Medical Program for the Department of

Veterans Affairs and the Civilian Health and Medical Program

of the Uniformed Services.

c. Less than one-half of one percent.

65 population would have spent an average of about

$62 per person (in 1987) if their coverage had been

similar to that of those who had employment-based

coverage.9 This amount represents a 77 percent increase in outpatient prescription drug expenditures.

The comprehensive coverage proposed by the

Administration is analogous to that of many employment-based plans. Logic would therefore suggest that the uninsured could increase their outpatient prescription drug consumption by approximately 77 percent under the Administration's proposal. Allowing for as much as a 25 percent error

in this estimate indicates that the uninsured may

increase their prescription drug expenditures by 58

percent to 96 percent under the Administration's

proposal. This range is in line with other CBO estimates. Also based on the NMES, CBO has estimated that the uninsured would spend 57 percent

more on all medical care if they were insured—a

figure that is close to the lower end of the estimated

range of increase.10 Previous research by CBO and

RAND indicates that prescription drug expenditures

are closely tied to coverage of physician visits.11

CBO has also estimated that the uninsured would

spend 97 percent more on professional health services if they were insured. It might be reasonable

to expect a similar increase in prescription drug expenditures.

Uninsured people constitute 17 percent of the

under-65 population, but according to NMES they

9. The NMES expenditures were also adjusted upward by 10 percent

to compensate for underreporting of drug expenses. The results of

Marc Berk, Claudia Schur, and Penny Mohr, "Using Survey Data

to Estimate Prescription Drug Costs," Health Affairs (Fall 1990),

suggest that underreporting is larger as a percentage of average

expenditures for those with low drug expenditures. This type of

underreporting would tend to bias the induced demand calculation

upward.

10. Congressional Budget Office, "Behavioral Assumptions for Estimating the Effects of Health Care Proposals," CBO Memorandum

(November 1993). These estimates assume that the uninsured

receive coverage similar to that currently provided by employment-based plans.

11. Congressional Budget Office, Updated Estimates of Medicare's

Catastrophic Drug Insurance Program. The RAND studies include Willard Manning and others, "Health Insurance and the

Demand for Medical Care," American Economic Review, vol. 77,

no. 3 (1987), and Arleen Leibowitz, Willard Manning, and Joseph

Newhouse, "The Demand for Prescription Drugs as a Function of

Cost-Sharing," Social Science and Medicine, vol. 21, no. 10

(1985).
CHAPTER THREE EFFECT ON THE DEMAND FOR PRESCRIPTION DRUGS 21

Table 2.

Induced Demand for Prescription Drugs by the Under-65 Population

Under the Administration's Proposal for Universal Coverage (In percent)

Insurance Status

Share of

Under-65

Population

Assumed Increase

in Outpatient

Prescription Drug

Expenditures

Estimated Increase in Expenditures

of the Under-65 Population

For Outpatient For All

Prescription Prescription

Drugs Drugs*

Uninsured

Employment-Based Insurance

Without a Drug Benefit

17 58 to 96

7.5 to 15

4.5 to 7*

0.2 to 0.3

4to6c

0.1 to 0.3

Privately Purchased

Health Coverage

Total

7

26

7.5 to 15

n.a.

0.5 to 1

5 to 8

0.4 to 0.8

5 to 7

SOURCE: Congressional Budget Office.

NOTE: n.a. = not applicable.

a. Outpatient prescription drugs make up approximately three-quarters of the sales of all prescription drugs. Column 4 equals 77 percent of

column 3.

b. This group accounts for only 8 percent of outpatient drug expenditures of the under-65 population. Calculation: (0.08)(58 to 96) = (4.5

to 7). The 8 percent is calculated by dividing the average expenditures of the uninsured by the average expenditures of all people under

65 (both according to the 1987 National Medical Expenditure Survey), then multiplying the result by the share of the population that is

uninsured. Calculation: (35/76)(0.17) = 0.08.

c. Includes 0.6 percent from the increase in inpatient prescription drug expenditures.

account for only 8 percent of the outpatient prescription drug expenditures of this age group. If the

uninsured were to increase their prescription drug

expenditures by 58 percent to 96 percent, outpatient

prescription drug expenditures of the entire under-65

population would increase by 4.5 percent to 7 percent (see Table 2).

Outpatient Drug Demand

and Improved Coverage

The Administration's proposal would improve the

coverage of people who are currently insured

through their employers but lack drug benefits. The

Bureau of Labor Statistics estimates that 3 percent

to 4 percent of those with employment-based plans

had no prescription drug coverage in 1991.12 This

group constitutes approximately 2 percent of the

under-65 population (3.5 percent of 66 percent).

CBO assumes, based on the NMES data, that adding a drug benefit alone to a group that already has

physician coverage would increase outpatient prescription drug expenditures by 7.5 percent to 15

percent.13 Giving a drug benefit to the 2 per12. Bureau of Labor Statistics, Employee Benefits in Medium and

Large Private Establishments, 1991. Four percent of those who

have employment-based health coverage through firms employing

fewer than 100 workers also had no prescription drug coverage.

See BLS, Employee Benefits in Small Private Establishments,

1990.

13. See the discussion below on the increase in prescription drug

expenditures for the 65-and-over population that currently has

coverage only through Medicare.
22 HOW HEALTH CARE REFORM AFFECTS PHARMACEUTICAL RESEARCH AND DEVELOPMENT June 1994

cent of the population who have only physician

coverage through their employers is likely to increase the total outpatient demand of the under-65

population for prescription drugs by less than 1 percent.

Both physician and drug coverage would generally improve for the portion of the population that

has private insurance. Privately purchased health

coverage is often not as extensive as employmentbased coverage. Nonetheless, the effects on the demand of the under-65 population for drugs prescribed on an outpatient basis would be relatively

small because the group constitutes only 7 percent

of its age category. If many in this group were to

receive better physician and drug coverage, the percentage of increase in prescription drug expenditures

should be close to the 7.5 percent to 15 percent calculated for those who already have adequate physician but not drug coverage. CBO assumes that under the Administration's proposal those who have

private coverage would also increase their outpatient

prescription drug expenditures by 7.5 percent to 15

percent. If that took place, the result would be an

increase in demand of about 1 percent for outpatient

prescription drugs by the entire under-65 population.

Inpatient Drug Demand

If the Administration's proposal for universal coverage were enacted, those who are currently uninsured

would also expand their inpatient use of pharmaceuticals because they would tend to increase their use

of hospital services. According to calculations

based on the NMES, those who were not insured

spent $330 a year in 1987 on hospital services (inpatient, outpatient, and emergency). If their coverage had been comparable to an employment-based

plan, they would have spent $424 a year (adjusting

for differences in population characteristics)-an increase of 28 percent. The uninsured account for

about 10 percent of total hospital expenditures.

Thus, a 28 percent increase in hospital expenditures

by those who are currently uninsured implies that

total hospital expenditures could rise by approximately 3 percent.14

 Assuming that inpatient prescription drug expenditures are a constant proportion

of all hospital outlays, expenditures for inpatient

prescription drugs could also rise by about 3 percent. Because the hospital market is roughly 23

percent of the total prescription drug market, the

total prescription drug expenditures for the under-65

population would increase by less than 1 percent

(0.6 percent).

Total Increase in Demand for

the Under-65 Population

Taken together, these calculations indicate that all

prescription drug expenditures of the under-65 population might rise from 5 percent to 7 percent if the

comprehensive coverage included in the Administration's proposal for health care reform were extended

to this entire age group (see the last column of

Table 2). The estimate does not take into account

the effect that a large shift to managed care plans

might have on the demand for prescription drugs.

Nor does it account for a greater use of generic

drugs. Because of the uncertainties involved in the

induced demand calculations, Chapter 6 considers a

broader range of changes.

Medicare's New Drug

Benefit

The Administration's proposal would add a new

drug benefit to Medicare. Because this would give

many Medicare enrollees drug coverage for the first

time, the demand for pharmaceuticals would increase. CBO estimates that the demand for outpatient prescription drugs by the 65-and-over population would rise by about 4 percent as a result of

expanded Medicare coverage. Because the outpatient market constitutes 77 percent of all prescription drug expenditures, and the 65-and-over population accounts for one-third of all spending on prescription drugs, the new Medicare drug benefit

would increase total U.S. expenditures on prescrip14. The calculation: 10 percent of 28 percent is 2.8 percent (rounded

to 3 percent). The 10 percent is calculated by dividing average

expenditures for the uninsured on hospital services by average

expenditures of the entire under-65 population on hospital services

and multiplying that result by the proportion of the population

uninsured in 1993, that is ($330/$551)*0.17 = 0.1.
CHAPTER THREE EFFECT ON THE DEMAND FOR PRESCRIPTION DRUGS 23

tion drugs by 1 percent. About 1 percent of the

under-65 population is also insured through Medicare. Therefore, this new drug benefit would also

have a very small effect on the prescription drug

expenditures of those who are under 65.

Under the Administration's proposal, the new

prescription drug benefit would require a patient to

meet a $250 deductible before prescription drug

coverage begins and would apply a 20 percent coinsurance rate thereafter. The benefit would include

an annual catastrophic cap of $1,000; once the patient had spent $1,000 on prescription drugs, all further expenditures on prescription drugs would be

covered in full.

There are currently two types of Medicare coverage: Hospital Insurance (HI) and Supplementary

Medical Insurance (SMI). Hospital Insurance is

available to all Social Security beneficiaries and

requires no premium. Those who are 65 and over

and are not eligible for Social Security may buy HI

at a monthly premium of $245. Hospital Insurance

covers inpatient hospital services, some skilled nursing facility services, and hospice care. Enrollment

in the SMI program is voluntary and requires a premium ($41.10 a month). Even people 65 and over

who are not eligible for Social Security can buy

SMI coverage at the regular premium. Supplementary Medical Insurance covers physician visits, outpatient hospital services, and laboratory services

after a $100 deductible is met. SMI covers 96 percent of Medicare enrollees who are 65 and over.15

The proposed drug benefit would be added to this

second part of Medicare. The current SMI premium

is set to cover one-fourth of the cost of the benefits

and the federal government pays the rest. The SMI

premium would be increased to cover one-fourth of

the cost of this new drug benefit.16

The proposed Medicare drug benefit plan would

encourage substitution of generic drugs. For multisource drugs, the reimbursement limit would be

based on the wholesale price of the drug that falls

in the middle of the group when drugs are ranked

15. Health Care Financing Administration, Medicare and Medicaid

Statistical Supplement, p. 14.

16. The increase would be larger for very high-income Medicare

enrollees.

by price (the median price). A drug is classified as

multisource if other bioequivalent substances are on

the market, a situation that occurs either because the

patent has been licensed so that more than one

brand-name version exists, or because the patent has

expired and there are generic substitutes. If there

are more generic than brand-name forms of the

drug, the reimbursement limit would be determined

by a generic drug. In this instance, a Medicare patient would have to pay extra for choosing a brandname drug. The reimbursement limit would also

apply when calculating the amount spent to reach

the $250 deductible. This lower reimbursement

limit on multisource brand-name drugs, however,

would not apply if the physician specifically prescribes the brand-name drug.

CBO did not take into account greater substitution of generic drugs in its induced demand calculations. The most important reason for excluding generic substitution from the induced demand estimates was not because it was difficult to gauge.

Generic substitution begins to erode sales only after

the brand-name drug's patent has expired (or the

patent on one of its brand-name competitors has expired). During the first 7 to 12 years that a brandname drug is on the market, it will not usually face

competition from generic substitutes. If induced

demand is estimated at 5 percent, a brand-name

drug's sales should increase by an average of 5 percent in the years before generic competition is

faced. When analyzing the changes in returns from

drug development, CBO took into account increased

substitution of generic drugs by examining greater

sales erosion at the end of a brand-name drug's life,

rather than by lowering the induced demand estimate.

Calculating Induced Demand

Most Medicare enrollees (96 percent) participate in

the SMI program. They must meet a $100 deductible before coverage begins. Thereafter, a 20 percent coinsurance rate applies, Thus, almost all

Medicare enrollees are covered for physician visits

and other basic health services, even if they do not

carry supplemental coverage. In 1991, only 11 percent of 65-and-over Medicare enrollees had no coverage supplementing Medicare (see Table 3).
24 HOW HEALTH CARE REFORM AFFECTS PHARMACEUTICAL RESEARCH AND DEVELOPMENT June 1994

Table 3.

Induced Demand for Outpatient Prescription Drugs by Medicare Enrollees 65 and Over

Share of Total

65-and-Over

Medicare

Enrollees8

Insurance Status (Percent)

Average

Outpatient Drug

Expenditures

per Enrollee

in 1987b

(Dollars)

Assumed

Increase in

Outpatient Drug

Expenditures

(Percent)

Corresponding

Increase in Total

Outpatient Drug

Expenditures of

65-and-Over

Medicare

Enrollees6

(Percent)

Supplemental Coverage

Individually purchased (medigap)

Employment-based retirement plans

Medicaid: dual eligibles

Qualified Medicare beneficiaries

Other

No Supplemental Coverage

Total

37

38d

9

3

2

11

100

267

287"

292

N.A.

N.A.

179

n.a.

7.5

0

0

7.5

7.5

7.5 to 15

n.a.

2.7

0

0

0.2

0.1

0.7 to 1.3

3.7 to 4.4

SOURCE: Congressional Budget Office. Column 1 is based on George S. Chulis and others, "Health Insurance and the Elderly," Health

Affairs (Spring 1993).

NOTE: N.A. = not available; n.a. = not applicable.

a. Based on Round 1 of the 1991 Medicare Current Beneficiary Survey (from Chulis and others). Includes the institutionalized population.

b. Based on the 1987 National Medical Expenditure Survey. Adjusted to control for health status, age, family income, sex, race and

ethnicity, marital status, education, employment status, and region of residence. Adjusted upward by 10 percent to account for underreporting. Underreporting will not affect the analysis insofar as it is evenly spread among subgroups.

c. Column 4 equals column 1 times column 3 times average expenditures of subgroup divided by average expenditures of all 65 and over

Medicare enrollees. 2.7 equals (0.37)(7.5)(0.99) and 0.7 to 1.3 equals (0.11)(7.5 to 15)(0.77). Total has been rounded.

d. Includes 5 percent who have both employment-based and individually purchased supplemental coverage.

e. People with union-based retirement plans, which tend to have more generous benefits than employer-based retirement plans, are not

included in this average.

Supplemental coverage picks up the coinsurance

payments (and occasionally the $100 deductible)

required by Medicare and may offer such additional

benefits as drug coverage. Thirty-seven percent of

65-and-over Medicare enrollees had supplemental

coverage through individually purchased plans

(medigap) in 1991. Most of these plans do not offer a drug benefit.17

 If a drug benefit were added to

Medicare, those people who do not have supplemental coverage and those who have only private

medigap coverage would increase their demand for

Pharmaceuticals.

People who have employment-based retirement

plans typically have both supplemental physician

and drug coverage. The employment-based retirement plans generally do not have a separate deduct17. One estimate, based on the NMES, states that 19 percent of those

people who have purchased medigap plans individually have prescription drug coverage. See Stephen H. Long, "Prescription

Drugs and the Elderly: Issues and Options," Health Affairs (Spring

1994), p. 161. Currently, the only drug coverage that a private

supplemental medigap plan may offer has a separate $250 deductible and a 50 percent coinsurance rate.
CHAPTER THREE EFFECT ON THE DEMAND FOR PRESCRIPTION DRUGS 25

ible for prescription drugs and some require that

beneficiaries pay only $1 to $4 per prescription.18

Currently, 74 percent of people who work for firms

employing 100 workers or more and who will obtain health benefits from their employers on retirement at age 65 will see little change in their coverage.19

 Such evidence suggests that the drug coverage offered by employment-based retirement plans

is usually as generous as the proposed Medicare

drug benefit. Therefore, no change in demand is

predicted for this group.

Private Supplemental Coverage (Medigap). Retirees age 65 and over who have employment-based

plans spend 7.5 percent more on outpatient prescription drugs than those who are insured through medigap plans (see Table 3). The increase is probably

attributable to the addition of drug coverage; employment-based retirement plans typically offer a

prescription drug benefit and most medigap plans do

not. CBO therefore concludes that the expenditures

for outpatient prescription drugs by 65-and-over

Medicare enrollees who are insured through supplementary plans that do not frequently offer drug benefits would increase by 7.5 percent if the proposed

prescription drug benefit were added to Medicare.

Enrollees who have supplementary coverage that is

equal to or better than the proposed drug benefit are

not expected to change their spending on drugs.

Those Eligible for Both Medicare and Medicaid.

Qualified Medicare beneficiaries (QMBs) constitute

another group of people who have supplemental

coverage but no drug benefits. These Medicare enrollees also qualify for assistance from Medicaid,

but are not eligible for Medicaid's drug benefit.

The income ceiling for QMBs was phased in at 85

percent of the poverty line in 1989 and reached 100

percent of the poverty line in 1992. It will rise to

120 percent of the poverty line in 1995. For those

in this group who are at or below the poverty line,

Medicaid picks up the premiums, coinsurance, and

deductibles required by Medicare's Supplementary

Medical Insurance program. Medicaid picks up

only the Medicare premium for those with incomes

above the poverty line (hence these QMBs have no

Medicaid coverage supplementing Medicare's costsharing requirements). Because the QMB program

did not exist in 1987, the increase in the number of

Medicare enrollees who were also eligible for Medicaid between 1987 and 1991 can be viewed as a

first approximation of the size of the QMB population. According to the 1987 NMES survey, 7.6 percent of Medicare enrollees were also eligible for

Medicaid (these were all dual eligibles). According

to the 1991 Medicare Current Beneficiary Survey,

11.9 percent of Medicare enrollees were also covered by Medicaid—an increase of 4 percentage

points.

Since the number of dual eligibles did not increase much between 1987 and 1991, CBO viewed

the 4 percentage point rise as indicative of the portion of the 65-and-over population who are QMBs

with incomes at or below the poverty line. (All

QMBs had incomes at or below the poverty line in

1991.) Some of this 4 percentage point increase,

however, occurred because the institutionalized

Medicare population was counted in the 1991 survey but not in 1987. The portion of this group that

qualifies for Medicaid is greater than that of the

entire 65-and-over population. Hence, the number

of QMBs may have been lower than 4 percent of all

65-and-over Medicare beneficiaries in 1991.20

For the purpose of this induced demand calculation, CBO assumes that the number of QMBs at or

below the poverty line is equal to 3 percent of all

65-and-over Medicare enrollees. Because this

group, like most of those who have private supplemental insurance, has supplemental physician coverage but no drug coverage, CBO assumes that people

in it would also increase their outpatient prescription

drug expenditures by 7.5 percent if the proposed

drug benefit were added to Medicare.

18. Congressional Budget Office, Updated Estimates of Medicare's

Catastrophic Drug Insurance Program, p. 51.

19. Bureau of Labor Statistics, Employee Benefits in Medium and

Large Private Establishments, 7997, Table 63.

20. Based on state-level data obtained from the Health Care Financing

Administration, the Congressional Research Service reports that

the number of QMBs was 1.3 million in 1992, or almost 4 percent

of the Medicare population. See Congressional Research Service,

Medicaid Source Book: Background Data and Analysis (January

1993). This number includes many people who not only qualified

for Medicaid under the QMB standards but also were eligible for

Medicaid's drug benefit. At the same time there were reporting

problems that could make this estimate too low.
26 HOW HEALTH CARE REFORM AFFECTS PHARMACEUTICAL RESEARCH AND DEVELOPMENT June 1994

Other Supplemental Coverage. The induced demand estimate presumes that people who have some

type of unspecified supplemental coverage would

also increase their outpatient drug expenditures by

7.5 percent if the drug benefit were added to Medicare. The group is so small, however, that the effect on the induced demand estimate is slight.

Those Without Any Supplemental Coverage. It is

assumed that people who have no supplemental coverage would increase their outpatient prescription

drug expenditures by 7.5 percent to 15 percent under the Administration's proposed Medicare drug

benefit. Medicare enrollees who are 65 years old

and older, and who have supplemental coverage

through employment-based retirement plans, spend

an average of 60 percent more on prescription drugs

than those who have no supplemental coverage (see

Table 3). But a large part of this difference is attributable not to drug coverage but to the fact that

many employment-based retirement plans offer supplemental coverage that picks up some of Medicare's cost-sharing requirements. The Administration's proposal affects drug coverage, but for the

most part not Medicare's deductibles and copayments.21

 It is therefore necessary to determine the

portion of this 60 percent difference that stems from

drug coverage alone.

Medicare enrollees who are 65 and over and

have employment-based retirement plans spend

about 7.5 percent more on prescription drugs than

those who have private supplemental coverage

(medigap), which usually does not include drug

coverage. Therefore, it is assumed that at least 7.5

percentage points of the 60 percent difference is

attributable to drug coverage.22 Another argument

suggests that up to 10 percentage points of the 60

percent difference could be attributed to prescription

drug coverage. Those who have no supplemental

coverage would have to spend 50 percent more on

prescription drugs to catch up with those who have

medigap coverage, plus an additional 10 percent to

catch up with those whose coverage is employment

based (and who usually have a drug benefit). In

addition, private medigap plans may pick up the

coinsurance payments required by SMI more often

than employment-based plans. Those who have

medigap coverage may spend almost as much on

prescription drugs as those who have employmentbased plans, partly because they have better physician coverage. It follows that the amount of the 60

percent difference that is attributable to drug coverage could be greater than 10 percentage points.

According to CBO tabulations of NMES data,

people who have no supplemental coverage purchased an average of 12 prescriptions a year, whereas retirees who have employment-based supplemental coverage bought an average of 16.6 prescriptions

per year, an increase of 38 percent. Therefore, of

the 60 percent difference in outpatient drug expenditures between those who have no supplemental coverage and retirees who have employment-based supplemental coverage, 38 percent is attributable to a

greater quantity of drugs purchased and 16 percent

is attributable to a higher price.23 Drug coverage

should increase both the quantity and the price of

prescriptions purchased, whereas physician coverage

should primarily affect the quantity of prescriptions

purchased.24

Previous RAND and CBO studies indicate that

most of the 60 percent difference should be attributed to increased physician coverage alone.25

 Attributing only the price increase to drug coverage

implies a 16 percent increase in outpatient drug expenditures for those who have no supplemental coverage. On the basis of this calculation and the results of previous studies, if a prescription drug benefit was added to Medicare, the most that prescrip21. The proposal would introduce coinsurance payments on lab services.

22. Congressional Budget Office, "Behavioral Assumptions for Estimating the Effects of Health Care Proposals."

23. If the quantity purchased rises by 38 percent on average, then the

price paid must rise by 16 percent on average to get a 60 percent

increase in expenditures.

24. Congressional Budget Office, Updated Estimates of Medicare's

Catastrophic Drug Insurance Program, pp. 47-50. These figures

were adjusted to account for differences in population characteristics.

25. The RAND studies include Manning and others, "Health Insurance

and the Demand for Medical Care," and Leibowitz, Manning, and

Newhouse, "The Demand for Prescription Drugs as a Function of

Cost-Sharing."
CHAPTER THREE EFFECT ON THE DEMAND FOR PRESCRIPTION DRUGS 27

tion drug expenditures could increase for those who

have no supplemental coverage is assumed to be 15

percent. Consequently, a range of 7.5 percent to 15

percent is used to reflect the probable response of

this group, which now has no supplemental coverage.

Total Demand Would Increase. On the basis of

these estimates, if the proposed prescription drug

benefit were added to Medicare, the outpatient prescription drug expenditures of all 65-and-over Medicare enrollees would increase by about 4 percent

(see Table 3). The amount that prescription drug

coverage is estimated to increase for each group discussed above is weighted by the group's share of

total prescription drug expenditures (by all 65-andover Medicare enrollees). This weight takes into

account the size of the group in relation to the entire Medicare population as well as the average prescription drug expenditures of each group.26

 Most

of the increase in demand results from extending

drug coverage to those currently covered by medigap plans and to the 11 percent of the elderly who

currently have no supplemental coverage at all.

One percent of the 65-and-over population has

no health insurance at all. Under the Administration's proposal, this group would be compelled to

buy into either Medicare's SMI program or a comprehensive plan offered by a health alliance. The

drug benefit that would be offered by Medicare is

almost identical to that offered under the high-costsharing plan. Therefore, whether they get it through

Medicare or an alliance plan, those who are 65 and

over and uninsured will obtain coverage that includes a drug benefit. No survey numbers are available on which to base an induced demand estimate

for this group. The estimate is therefore based on

the 77 percent increase in expenditures projected for

the uninsured people under 65. It follows, then,

that if and when those who are not only 65 and

over but uninsured as well receive coverage for the

first time, the expenditures of all those 65 and over

on outpatient prescription drugs would increase by

no more than one-half of one percent.27

The Administration's proposal would increase

the outpatient prescription drug expenditures of 65-

and-over Medicare enrollees by about 4 percent. In

1990, 29.4 million U.S. residents 65 years old or

older were enrolled in the SMI program. The total

number of people in the United States 65 years old

or older was 31.1 million. Therefore, approximately

95 percent of the 65-and-over population is covered

by Medicare's SMI program.28 Taking into account

the small increase caused by extending drug coverage to the uninsured 65-and-over population, CBO

estimates that the increase in outpatient prescription

drug expenditures for all people 65 and over would

also be about 4 percent.

Approximately 3.6 million Medicare enrollees

are under age 65. They constitute less than 2 percent of the under-65 population (see Table 1). Because they are such a small portion of the under-65

population, their increase in outpatient drug expenditures under Medicare's new drug benefit would

not alter the estimated 5 percent to 7 percent increase in prescription drug expenditures for the population that is under 65 years old.

Conclusions

CBO calculates that universal coverage as proposed

by the Administration could increase the under-65

population's demand for prescription drugs by approximately 5 percent to 7 percent. Because twothirds of all prescription drugs are purchased by

people under age 65, the resulting increase in demand would cause total prescription drug expenditures to rise by 3 percent to 5 percent. Most of the

increase in demand would result from extending

coverage to the 37 million uninsured (99 percent of

26. In constructing these weights, CBO assumes that the average

expenditures of those with "other" coverage and those with Medicaid but no drug benefit are the same as the average expenditures

of those with coverage through medigap, since these categories

did not exist in the 1987 NMES.

27. As in the case of the uninsured under-65 population, it is assumed

that this group's share in total drug expenditures is equal to just

under half of its share of the total population.

28. Health Care Financing Administration, Medicare and Medicaid

Statistical Supplement, pp. 14, 18-19, and Bureau of the Census,

Statistical Abstract of the U.S., 1993.
28 HOW HEALTH CARE REFORM AFFECTS PHARMACEUTICAL RESEARCH AND DEVELOPMENT June 1994

whom are under age 65). The rest would be caused

largely by those who have private insurance and

would receive better health insurance coverage under the Administration's proposal.

Medicare's new drug benefit could increase the

demand of the 65-and-over population for outpatient

prescription drugs by about 4 percent. Since onethird of all prescription drug expenditures are made

by people 65 and over, and 77 percent of prescription drug expenditures are outpatient, this increased

demand would raise total prescription drug expenditures by approximately 1 percent. Many Medicare

enrollees already have prescription drug coverage

through retirement plans. Much of this increase

would be caused by those who have only private

medigap coverage, which usually does not include

prescription drug insurance, and the 11 percent of

Medicare enrollees who have no supplemental coverage at all.

Overall, CBO estimates that the universal coverage provision and the Medicare drug benefit proposed by the Administration would increase total

prescription drug expenditures by approximately 4

percent to 6 percent.
Chapter Four

The Rebate on Medicare Prescription

Drugs and the Advisory Council

on Breakthrough Drugs

B

ecause its proposal would give all legal residents of the United States a pharmaceutical

benefit that could create a windfall for the

industry, the Administration hopes to ensure that the

U.S. taxpayer would not be excessively penalized

for providing new benefits to Medicare beneficiaries. At the same time, the Administration has

reason to be skeptical of formal price controls.

Consequently, it has devised new mechanisms for

containing costs.

The Medicare Drug

Rebate Agreement

The proposal submitted by the Administration

would require that a pharmaceutical manufacturer

enter into a rebate agreement with the Secretary of

Health and Human Services (HHS) if a drug is to

be covered under Medicare's new drug benefit

provision. Modeled after the existing Medicaid

rebate, the proposal's agreement requires that pharmaceutical manufacturers pay a rebate to the federal

government on all brand-name drugs purchased

through Medicare. Generic drugs are exempt.

price paid to pharmaceutical manufacturers for

drugs sold by pharmacies and other retailers.1 Manufacturers usually charge institutional purchasers,

such as health maintenance organizations and hospitals, a lower price than retail pharmacies charge for

the same drug. The rebate would be larger if the

difference between the average manufacturer retail

price and the average price paid by institutional

purchasers exceeds 17 percent. In that case, the

rebate would equal the average discount given to

institutional purchasers. Specifically, it would be

equal to the amount by which the average manufacturer retail price exceeds the "average manufacturer nonretail price" (defined as the discounted

price that institutional purchasers pay for the drug).2

This formula ensures that the government would

pay no more for a drug purchased through Medicare

than the average institutional purchaser. And the

government would pay less than institutional purchasers when the average institutional discount is

less than 17 percent. Although the discounts given

to institutional purchasers can be partially justified

on the grounds that bulk purchases lower distribution costs, this would not be true for drugs bought

through Medicare.

Calculation of the Rebate

Under the Administration's proposal, the rebate

would be no less than 17 percent of the "average

manufacturer retail price," which is defined as the

1. Health Security Act (H.R. 3600 and S. 1757, 103rd Congress, 1st

Session, 1993), Title II, Subtitle A, Sec. 2003(f)d).

2. Health Security Act, Title II, Subtitle A, Sec. 2003(0(2). The

purchases of the Department of Defense and the Department of

Veterans Affairs are included in the calculation of the average

manufacturer nonretail price.
30 HOW HEALTH CARE REFORM AFFECTS PHARMACEUTICAL RESEARCH AND DEVELOPMENT June 1994

The rebate might be increased further if the

average manufacturer retail price of a drug rose

faster than the consumer price index. (The Medicaid rebate has a similar provision.) The rebate

would be increased to offset any increase in the

price of the drug above the inflation rate.

The Administration's proposal also includes a

specific provision that requires the manufacturer to

charge the same price to all wholesalers, retailers,

and institutions that purchase drugs on the same

terms. These terms include "prompt payment, cash

payment, volume purchase, single-site delivery, the

use of formularies by purchasers and any other

terms effectively reducing the manufacturer's

costs."3 Many reasons therefore exist for differences in the terms of purchase. Buyers, such as retail pharmacies, that do not use formularies (lists of

drugs that may be prescribed) could be charged a

different price, even for the same quantity of drugs,

than the institutional purchasers that do use them.

In addition, formularies differ in their restrictiveness, a disparity that may constitute a difference in

the terms of purchase. Apparently, this equal-pricing provision may not prevent manufacturers from

granting greater discounts to hospitals and health

maintenance organizations than to retail pharmacies.

The proposed Medicare rebate agreement would

require that the pharmaceutical firms report to the

Secretary of HHS the amount of their average manufacturer retail and nonretail prices on each drug

covered by Medicare. In addition, the Secretary

would be empowered to inspect the records of manufacturers and survey wholesalers, pharmacies, and

institutional purchasers of drugs "as necessary" to

verify reported prices.4 Financial penalties of up to

$100,000 could be imposed on manufacturers who

refuse to comply.

The manufacturer could terminate the rebate

agreement with the Secretary at any time. In that

case, however, Medicare would not cover any of the

manufacturer's drugs. Manufacturers would not be

able to exclude some of their existing drugs from

the rebate agreement. All of a manufacturer's drugs

would be covered or none would be covered.

Drugs introduced after June 1993 would be an

exception. The Secretary may negotiate a higher

rebate than 17 percent on these drugs. If no agreement can be reached between the Secretary and the

manufacturer on the rebate amount, that drug may

be excluded from coverage and the remainder of the

manufacturer's drugs would still be covered by

Medicare.

Problems with Reporting

In practice, isolating a price paid to the manufacturer for drugs sold at retail is difficult. Most retailers, primarily pharmacies, buy drugs through a

wholesaler, but so do many institutional purchasers.

About three-quarters of all drugs are distributed

through independent wholesalers to both pharmacies

and such institutional purchasers as hospitals.

About 22 percent of the wholesalers' business consists of sales to hospitals.5

 It is therefore difficult to

calculate the average manufacturer retail price on

the basis of the price charged to wholesalers. This

calculation is currently done, however, for the Medicaid rebates, based on prices reported by the pharmaceutical companies.

Under the Administration's proposal, the Secretary would report to the manufacturer the quantities

of drugs purchased through Medicare on which a

rebate must be paid. Rebates are likely to be requested on all drugs purchased by Medicare enrollees, even those that fall under the $250 deductible

and are therefore not paid for by Medicare.6 Underreporting could be a problem for Medicare enrollees

whose drug purchases never exceed the $250 deductible. Medicare enrollees who spend less than

$250 on drugs would have no incentive to report

these expenditures, and neither would the pharma3. Health Security Act, Title II, Subtitle A, Sec. 2003(e).

4. Ibid., Title II, Subtitle A, Sec. 2003(b)(3)(C).

5. Mickey Smith, Pharmaceutical Marketing, Strategy and Cases

(New York: Pharmaceutical Products Press, 1991), p. 50.

6. Health Security Act, Title II, Subtitle A, Sec. 2003(b)(l)(B).
CHAPTER FOUR THE REBATE ON MEDICARE PRESCRIPTION DRUGS 31

cist.7 According to Congressional Budget Office

calculations, the prescription drug expenditures of

the 65-and-over Medicare enrollees who spent just

$300 or less constituted 10 percent of total outpatient prescription drug expenditures in 1987.8

 For

this reason, somewhat less than 10 percent of drug

expenditures by Medicare enrollees could go unreported. Therefore, no rebate would be paid on these

sales.

lower price.9 If a rebate could not be negotiated,

the Secretary could exclude the drug from reimbursement by Medicare. The company would have

six months after marketing approval by the Food

and Drug Administration to negotiate the rebate.

Because Medicare beneficiaries represent more than

one-third of the total pharmaceutical market, such a

refusal is widely viewed as hurting the chances of

commercial success of most drugs.

The Medicare Rebate

for New Drugs

An additional rationale for examining drug launch

prices is that in order to compensate themselves for

the proposed Medicare rebate and in anticipation of

not being able to raise prices later, pharmaceutical

companies might be tempted to launch new drugs at

high prices. The government would therefore want

some way of controlling this effect.

The Administration's proposal would affect the

prices of new drugs in two ways: through the Medicare rebate agreement and through the Advisory

Council on Breakthrough Drugs. The Administration's proposal includes special rules for negotiating

the Medicare rebate on new drugs. In addition, the

Advisory Council on Breakthrough Drugs would

examine the reasonableness of the prices of new

drugs that bring significant new therapeutic potential

to the marketplace.

For any drug that was first marketed after June

1993, Medicare could negotiate a special rebate if

the Secretary of HHS believes the drug is priced

excessively or finds that it is marketed abroad at a

7. Unless the pharmacist bills Medicare, which then bills the Medicare enrollee for the drug. The current Secretary of Health and

Human Services has granted a contract to GTE Government Systems Corp. to design a computerized billing system for Medicare;

the enrollee will need only to present a card to the doctor and

Medicare will bill the patient for what is not covered. Spencer

Rich, "Medicare Billing to Join Electronic Superhighway," The

Washington Post, January 20, 1994, p. A21. This system could be

applied to Pharmaceuticals, obviating the reporting problem.

8. Congressional Budget Office, Updated Estimates of Medicare's

Catastrophic Drug Insurance Program (October 1989).

Evaluating New Drug Prices

One aspect of this provision is that the Administration's proposal requires a determination of the potential for a special rebate on all new drugs, with

the Advisory Council responsible only for breakthrough drugs. The Administration's proposal, however, presents no institutional mechanism, other than

through the Secretary of HHS, by which the appropriateness of the prices of nonbreakthrough new

drugs, which constitute the vast majority of new

Pharmaceuticals, is to be determined. As a result,

the Secretary might have to expand the role of the

Advisory Council.

If the price of a drug in any one of almost two

dozen foreign (mostly European) countries specified

in the Federal Food, Drug and Cosmetic Act

(FFDCA) were significantly below its U.S. versions'

average retail price, the Secretary could begin special rebate negotiations on new drugs reimbursed

through Medicare.10 Since the prices of drugs

newly introduced into the United States are unlikely

to be lower than the prices in all of the FFDCAspecified countries, all new drugs could be subject

to special rebate negotiations. The Administration's

proposal states that the new drug rebate can be no

greater than the difference between the wholesale

price in any one of the specified countries and the

average retail price of drugs manufactured in the

United States.

The proposal outlines various factors that the

Secretary would use to deliberate on and negotiate

with drug manufacturers, namely:

9. Health Security Act, Title II, Subtitle A, Sec. 2003(c).

10. Ibid., Title II, Subtitle A, Sec. 2003(c)(3)(A)(ii).
32 HOW HEALTH CARE REFORM AFFECTS PHARMACEUTICAL RESEARCH AND DEVELOPMENT June 1994

O

O

Prices of other drugs in the same therapeutic class;

Manufacturer's cost information;

Factors affecting costs, such as projected

prescription volume, economies of scale,

product stability, and special manufacturing requirements;

Foreign drug prices; and

Other relevant factors.

These criteria use guideposts that private actors

in the market typically use to set prices, but adapt

them to federal policy. If the criteria were applied

mechanically or punitively, they could substantially

reduce the return on new drugs (breakthrough or

otherwise) purchased frequently by Medicare enrollees. If applied with judgment, some analysts

argue, the criteria could protect the taxpayers' interest without harming the drug companies. Until the

uncertainty concerning the ways in which they

would be applied becomes clear, however, these

provisions significantly increase the risk of developing new drugs.

The FDA has approved 90 nongeneric drugs a

year, or an average of one every four days, during

the last 20 years. Arriving at a clear judgment

about an appropriate price (and rebate) for each of

these may prove difficult. The very number of

decisions suggests that mechanical interpretations of

the law would be common.

Prices of Similar Drugs. Prices of other drugs in

the same therapeutic categories (the first criterion)

are certainly relevant in deciding how reasonably a

new drug is priced. New drugs under review often

offer benefits that other drugs in the category do

not. (In most instances, unless they do offer new

benefits, new drugs are priced at or below existing

drugs.) What are these additional benefits worth?

In some markets, great advances in performance are

sometimes not highly valued because current technology is "good enough." In other instances, even a

small improvement in therapy or convenience is

valuable to consumers.

Thus far, because insurance has often insulated

patients from the full costs of health care, or doctors

have made decisions for them, patients have not had

to make the types of cost-performance trade-offs

faced by consumers in other markets. Consequently, it is exceptionally difficult to judge the

value of product improvements in the pharmaceutical market. There is little data on how consumers

really value new drugs. In the past, the concern

was relatively unimportant because most of the

evaluations by consumers were private. But under

the Administration's proposal, the Secretary would

represent the official position of the federal government (and the willingness of taxpayers to pay) as to

the economic value of a particular drug in a given

therapeutic category.

In their efforts to control overall health (not just

drug) costs, doctors and other health providers have

begun to consider not only the purchase price of

medicines, but also their cost-effectiveness. The

whole concept of deciding the economic value of

pharmaceutical therapy (pharmacoeconomics) is

relatively new and many questions regarding methodology and intangibles remain unanswered.11

Manufacturers' Costs. Most important, how

would research and development and other fixed

costs be accounted for in calculating the reasonableness of the introductory price? Although the

Administration's proposal does not mention R&D

and other fixed costs specifically, these factors dominate average drug costs.

Each commercially successful product must pay

for its own R&D and for the R&D of products that

fail technically and commercially. Obviously, not

every successful product carries all of the costs of

the unsuccessful ones. How would the Secretary

determine what share of a firm's total R&D each

product should be expected to pay? Using industry

averages as guideposts makes it difficult to set

individual prices because there are such wide devia11. William McGhan, "Pharmacoeconomics and the Evaluation of

Drugs and Services," Hospital Formulary (April 1993), pp. 365-

378; Stephen Coons and Robert Kaplan, "Quality-of-Life Assessment: Understanding Its Use as an Outcome Measure," Hospital

Formulary (May 1993), pp. 486-498; and Tracy Skaer, "Applying

Pharmacoeconomics and Quality-of-Life Measure to the Formulary

Management Process," Hospital Formulary (June 1993), pp. 577-

584.
CHAPTER FOUR THE REBATE ON MEDICARE PRESCRIPTION DRUGS 33

tions among the industry averages. Pharmaceutical

companies try to recover as much as possible

through their successes, but are limited by market

forces. Like the previous criterion—prices of similar

drugs—this one uses guideposts that private actors in

the market typically use independently of each other

and turns them into federal policy for the entire

market.

Factors Affecting Costs. The Secretary would obtain data on, or estimate, economies of scale, the

expected size of the market, special manufacturing

requirements, and product stability in order to determine the reasonableness of a drug's launch price.

In some sense, the Secretary would be seeking data

similar to that sought by public utility regulatory

commissions when they set electrical or telephone

rates. As with a regulatory commission, price levels

could be set with relative ease, given some target

rate of return.

There are substantial differences, however,

between the pharmaceutical and utilities industries.

The sales of a utility probably vary much less than

those of a new drug. Utilities rarely sell a new

product, while drug companies do so all the time.

Forecasting the market size of any new product is

notoriously difficult. Medicare officials could not

be expected to know whether the drug companies

should amortize the R&D and other fixed costs over

10 million pills or 100 million pills. Consequently,

when the Secretary calculates the rate of return, he

or she would be doing so with much poorer information than that available to a typical regulatory

agency.

Foreign Drug Prices. Foreign prices, though often

useful as a starting point for analysis, can be misleading if they are not put into an appropriate institutional context. For example, until 1993 Canada

licensed drugs on a compulsory basis.12 Companies

had to allow other manufacturers to make and sell

their drugs before the patent ran out. The result

was competition among firms producing the same

brand-name drugs and charging lower prices than in

the United States.13 Since the Canadian market is

small, U.S. pharmaceutical companies have been

willing to enter that market and license their products; they may not make large profits in Canada,

but they can spread their fixed R&D costs further.

Another question facing federal authorities is

how to determine which of the foreign prices are

reliable indicators of recovery costs. Some prices

are determined by foreign health authorities acting

as buyers on behalf of their citizenry, using their

market power equally against both domestic and

foreign pharmaceutical makers. By contrast, other

countries that would be used for comparison do not

have a domestic pharmaceutical industry that performs world-class R&D and may be willing to negotiate low prices. Using the wrong set of foreign

prices might result in prices fixed below the level of

R&D cost recovery.

In other instances, exchange rate fluctuations

could quickly drive a wedge between U.S. and some

foreign prices, even if launch prices were similar.

This could occur especially when a country was

experiencing a drop in the value of its currency.

This criterion might also provide pharmaceutical

companies with incentives to introduce their drugs

first in high-price countries, so as to have only high

foreign prices for purposes of domestic comparison.

Such actions could reduce the availability of new

drugs in countries with histories of low prices.

Some economists argue that for industries in

which many costs are large and fixed, such as the

airline or pharmaceutical industries, those consumers

who are most willing to pay should bear those

costs. In the airline industry, it is the business

traveler who bears these fixed costs. Thus, if U.S.

consumers are most willing to pay for new medical

technology, they should bear a disproportionate

share of the costs. Under these circumstances,

international comparisons of prices would be misleading, especially when some U.S. customers pay a

lower price because they have joined a health plan

that manages the pharmacy benefit. Since the proposal uses average retail price, international com12. The debate over mandatory licensing of patents is much broader

than drug pricing and will not be dealt with here.

13. General Accounting Office, Prescription Drugs: Companies Typically Charge More in the United States Than in Canada (September 1992).
34 HOW HEALTH CARE REFORM AFFECTS PHARMACEUTICAL RESEARCH AND DEVELOPMENT June 1994

parisons would overlook all those U.S. customers

who are buying their drugs through such cost-saving

plans. In this context, international comparisons

would be between the least cost-sensitive U.S. consumer and the average foreign consumer.

Other Relevant Factors. The proposal's last set of

criteria, designated as "other relevant factors," is

undefined. But the Advisory Council's list of evaluative criteria does contain two additional entries

that may serve as guidelines. These concern the

cost-effectiveness of new drugs and their effects on

the quality of life.

The Advisory Council on

Breakthrough Drugs

Under the Administration's proposal, when the FDA

approves any new drug representing a significant

therapeutic advance (or breakthrough), the launch

price would be subject to review by an Advisory

Council on Breakthrough Drugs.14 The Advisory

Council's findings, unlike the Medicare rebate negotiations, would be public and thus could have influence beyond the federal market. As the name implies, the Advisory Council has no direct legal power, but affects prices only through other economic

actors-Medicare and other health plans-should they

choose to listen to the council's opinion. Of course,

the Advisory Council might help form public opinion, which has been quite powerful on occasion, but

which is difficult to model or predict.

The 13 members of the Advisory Council, who

would be appointed by the Secretary of HHS, would

be responsible for determining whether or not the

launch price of a breakthrough drug was "reasonable." The Secretary of HHS would publish the

council's determination, together with minority

opinions, in the Federal Register.

Depending on how the proposed legislation is

interpreted, the Advisory Council might play a role

in only a very small number of drug introductions.

Although the Administration's proposal does not

Figure 8.

FDA Approval of New Drugs

(By therapeutic categories)

1,000

100

10

Number Approved

All New Drugs

1975 1980 1985 1990

SOURCE: Congressional Budget Office based on data provided

by the Food and Drug Administration (FDA).

NOTE: Vertical scale is logarithmic.

a. In 1979, the FDA approved no breakthrough drugs.

define the term "significant advance over existing

therapies," the FDA has used this classification for

years and only recently switched to a new method

of grouping. Between 1975 and 1991, the FDA

approved an average of 22 new drugs (new active

ingredients, which the FDA calls new molecular

entities) each year (see Figure 8).15 The breakthrough category, promising major new therapeutic

potential, accounts for one-seventh of all new

molecular entities, or about three drugs each year.

(Including those new molecular entities that have

only modest therapeutic potential would increase the

14. Health Security Act, Title I, Subtitle F, Sec. 1572.

15. A new molecular entity is an active ingredient that has never been

marketed before in this country. Other categories of FDA approval include derivatives of existing active ingredients and new

formulations, combinations, uses, or manufacturers. These other

categories could easily become commercially important without

receiving regulatory priority. In total, the FDA averaged about 90

approvals a year for nongeneric drugs during the 1975-1991

period. For a description of FDA classification of drug approval

applications, see Food and Drug Administration, FDA Consumer

Special Report; From Test Tube to Patient: New Drug Development in the United States (January 1988), p. 30. All of these

numbers exclude so-called biological preparations, such as blood

products, which are handled differently by FDA and constitute

about 5 percent of pharmaceutical sales.
CHAPTER FOUR THE REBATE ON MEDICARE PRESCRIPTION DRUGS 35

total to about 11 drugs a year.) Thus, the Advisory

Council could only consider a handful of cases each

year if it were working on breakthrough drugs

alone.

By contrast, if the proposal is interpreted to

include new uses of existing drugs and other

modifications of potential commercial (or medical)

importance, the Advisory Council might play a

more central role. The FDA's therapeutic classification system does not correspond to eventual commercial importance. (For example, Zantac, the

world's best-selling drug, was not classified as a

breakthrough drug by the FDA.) The classification

system serves only to allocate FDA resources.

Whether this system would be appropriate for another purpose is open to question.

Although very few drugs can be classified as

breakthroughs, many companies undertake R&D

fully intending to develop such a drug. Thus, even

if the actual number of drugs directly involved is

small, the effects on pharmaceutical companies can

be much greater, especially because each company

depends on a small number of drugs for a disproportionate share of its sales.

The Administration's proposal directs the Advisory Council to use many of the same evaluative

criteria as the Secretary of HHS, although the Advisory Council would also explicitly consider research

costs, which are not specifically included in the

Medicare criteria. Many of the same observations

about these criteria apply to the Advisory Council's

findings. In addition, the Administration's proposal

includes two other important evaluative standards:

o Cost-effectiveness, in relation to other pharmaceutical and nonpharmaceutical treatment; and

o Improvements in the quality of life, including

the ability to work and live a normal existence.

Obviously, these additional criteria make the

deliberations of the Advisory Council much more

complete than those prescribed by the Administration's proposal for the Medicare rebate. But even

these broader principles present problems. A new

drug may be cost-effective in relation to its pharmaceutical predecessors and surgical alternatives, but

still be more expensive than necessary to reward the

investors and company for their expenses and risk.16

Given the higher-than-normal profits for the industry, many breakthrough drugs may be in this position.

The Advisory Council might duplicate some of

the work of the Agency for Health Care Policy and

Research within the Public Health Service. The

agency's missions encompass evaluating and reporting on the effects of new health care technology,

including pharmaceutical therapy, with respect to

health care costs, productivity, and market forces.

(It also reports on safety, appropriateness, and efficacy, but that is less relevant here.) One division

has a staff of more than 150 working in the area of

health care costs, quality, and access. Another division focuses on outpatient pharmaceutical projects,

including cost containment mechanisms. In addition, the agency regards the broadest dissemination

of its research as part of its mission. In fiscal year

1994, the Congress appropriated $135 million for

the agency. This organization might expand substantially under the Administration's proposal.

Unlike the Medicare rebate, which would exist

ostensibly to protect the taxpayer, the Advisory

Council would be created to judge prices for the

public as a whole. It would not be the first time

that the federal government has tried to determine

the reasonableness of prices. In general, however,

federal agencies have found it extremely difficult to

determine what a reasonable price is, especially in a

dynamic market like pharmaceuticals. The Supreme

Court expressly disavowed imposing a "reasonableness" test in price-fixing cases because it was so

difficult to determine and changed constantly.17

What was "reasonable" in one year might not be a

year later. In other areas, even those in which price

regulation continues, federal and state regulators are

moving toward mechanisms that would permit the

market to have more influence in determining final

prices.

16. Statement of Judith Wagner, Office of Technology Assessment,

before the Senate Special Committee on Aging, November 16,

1993.

17. F. M. Scherer and David Ross, Industrial Market Structure and

Economic Performance, 3rd ed. (Boston: Houghton Mifflin Company, 1990), p. 336.
36 HOW HEALTH CARE REFORM AFFECTS PHARMACEUTICAL RESEARCH AND DEVELOPMENT June 1994

Effects on the

Pharmaceutical Market

sales (or some other financial target), rather than

profits, could be in this position and might be able

to increase their profits in the non-Medicare market

by raising prices.

Pharmaceutical manufacturers may attempt to raise

prices in order to compensate for the proposed 17

percent rebate. In general, a manufacturer cannot

charge the Medicare and non-Medicare populations

different prices for the same drugs because most

drugs are distributed through wholesalers and other

intermediaries. Therefore, a manufacturer would

have to try raising prices for all users of a drug.

Typically, economists assume that the costs of

government actions, like the rebate, are shared by

consumers and producers according to their relative

sensitivities to changes in price. In this instance,

however, not all sales of a drug would be subject to

the rebate. Instead, only the purchases by Medicare

beneficiaries would be affected. The purchases and

profits of the drug companies for their sales to nonMedicare patients would not be affected.

Companies that raise the prices of their product

typically lose market share. If the drug companies

are already charging the prices that give them the

highest profits, they cannot fully offset the rebate by

raising prices.

The provision in the Administration's proposal

that grants the Secretary of HHS the power to raise

the Medicare rebate if the price of a drug rises

faster than inflation is intended to make it more

difficult for drug companies to raise prices to compensate for the rebate. The additional rebate could

largely offset the benefits to the company from raising prices. The added rebate may prevent a drug

company from raising its prices because the increase

in the rebate would deprive it of additional revenues

from Medicare sales. In addition, the higher price

could decrease its share of the Medicare market. A

price increase might also reduce market share (and

possibly profit) for its non-Medicare sales.

If drug companies are not currently charging

prices that guarantee them the highest profit, they

might be able to circumvent at least part of the

rebate through price increases. Firms that price

their product to guarantee the maximum level of

Effects on the Role of Government

in the Pharmaceutical Market

As a result of Medicare's actions, sometimes in

conjunction with the Advisory Council, the federal

government might have substantial influence on the

prices of many Pharmaceuticals. Medicare would

set the initial rebate based on the "reasonableness"

of the launch price. After the launch period, the

Medicare rebate would rise if a pharmaceutical

company increased its prices above the rate of inflation. Consequently, the federal government would

be sending strong signals to drug manufacturers

about launch price and subsequent price increases.

But the use of these policy mechanisms would

oppose a 15-year trend in government policy toward

regulated industries, which has been to eliminate

price and quantity regulations while retaining quality and safety standards.18

Seen from another perspective, the Medicare

rebates do not constitute price controls but serve the

public purpose of limiting taxpayer costs. Before

the 1990 Omnibus Budget Reconciliation Act established the Medicaid rebate and other cost containment provisions, Medicaid was paying some of the

highest prices on the market. Without similar controls, some fear that Medicare could incur substantial costs. Furthermore, under the Administration's

proposal, the Secretary of HHS must set the price

that the federal government is willing to pay for

new products, just as the operator of any other

health plan does. Supporters of the proposal argue

that the special rebate for new drugs, though imperfect, is adequate to ensure that the taxpayer is protected. The rebate agreement in no way legally

limits prices charged to non-Medicare patients.

18. In 1977, 17 percent of U.S. gross national product was produced

by regulated industries. By 1988, the regulated industries' share

of GNP had been cut to 6.6 percent. Clifford Winston, "Economic Deregulation: Days of Reckoning for Microeconomists,"

Journal of Economic Literature (September 1993), pp. 1263-1289.
CHAPTER FOUR THE REBATE ON MEDICARE PRESCRIPTION DRUGS 37

Furthermore, findings of the Advisory Council are

not legally binding on any organization.

Effects on Discounts to

Institutional Buyers

As a result of the proposal's rebate agreement, institutional purchasers could pay a higher price for

drugs. Based on interviews with representatives of

drug companies, the Boston Consulting Group estimates that discounts given to institutional purchasers

in 1992 averaged 16 percent less than list price.19

Wholesalers commonly receive a discount from the

list price. Therefore, the discount from the "average

manufacturer retail price" would be lower.

The Medicaid rebate on a drug exceeds 15.7

percent if the best discount given to an institutional

purchaser of the drug exceeds this amount. Based

on a sample of 100 patented drugs for which the

Medicaid program currently spends the most money,

the Congressional Budget Office found that the

median best discount given to institutional purchasers was 18 percent off the average manufacturer's

price (approximately the price paid by wholesalers

and the Medicaid rebate equivalent of the "average

manufacturer retail price"). Since the average discount given to institutional purchasers would be

lower than the best discount given to any institutional purchaser, the amount that brand-name drugs

are discounted for institutional purchasers may often

average below 17 percent.

Discounts for institutional purchasers are currently smaller than they might be without the Medicaid rebates. The incentive to give institutional

purchasers discounts of more than 17 percent on

drugs purchased by Medicare beneficiaries would

diminish, but perhaps no more than it has already

diminished under the Medicaid rebate agreement. If

the amount of the drug consumed by Medicare beneficiaries is large enough in relation to the total demand for the drug, the manufacturer is likely to

keep its average discount rate to institutional purchasers at or below 17 percent.

19. Boston Consulting Group, The Changing Environment for U.S.

Pharmaceuticals (New York: Boston Consulting Group, April

1993), p. 10.

Effects on Launch Prices

Part of the Medicare rebate could be recovered by

setting a higher launch price. Since market share

declines when price increases, it may not be possible for pharmaceutical firms to recover the rebate

fully by raising prices. If manufacturers do not

raise launch prices, they would be able to recoup

part of the revenues lost to the rebate only by lowering negotiated discounts to institutional purchasers.

Drug manufactures could raise their launch

prices and not necessarily incur a special rebate.

The average new drug is currently launched at 14

percent below the price of the market leader. Pharmaceutical companies know that they would not be

allowed to raise prices beyond the increase in the

consumer price index without incurring an additional Medicare rebate. This knowledge would

encourage them to increase their introductory prices

on new drugs. Thus, instead of launching new

drugs at an average of 14 percent below the market

leader, pharmaceutical companies could introduce

them at, say, 7 percent under the market leader.

(Given the uncertainty surrounding all aspects of

marketing a new drug, there may be a great deal of

play in the current launch price.) Since the new

drug prices would be less than the prices of existing

drugs in the therapeutic category, pharmaceutical

companies might not have an additional Medicare

rebate beyond the 17 percent. But prices would be

higher than they otherwise would have been. Furthermore, if launch prices are higher, the position of

the market leader may be strengthened and the role

of the imitator in restraining prices may be reduced.

Effects on Competition

Some aspects of the drug market challenge popular

notions about the ability of producers to keep prices

high and the role of high prices in encouraging

competition. As noted previously, generic drugs are

not the only source of competition. Imitative brandname drugs also play a role in bringing down

prices, often before the patent expires. If the Medicare rebate on imitative drugs is set too high, the

effect could be to discourage early entry and competition. If the rebate is extended to generic drugs,
38 HOW HEALTH CARE REFORM AFFECTS PHARMACEUTICAL RESEARCH AND DEVELOPMENT June 1994

as the Medicaid rebate currently is, competition in

the industry would be discouraged even more.20

Effects would not be felt immediately because drug

companies are likely to finish projects that are already nearing completion.

Effects on Biotechnology

Many biotechnology products would be subject to

the rebate. An informal count of two dozen approved biotechnology products found that two-thirds

could be used on an outpatient basis, either exclusively or in addition to inpatient use. Others are

exclusively used on an inpatient basis and so would

not be subject to the rebate. Several hundred biotechnology products now await approval or are in

clinical trials. CBO has no breakdown of their inpatient or outpatient status. If a product is an outpatient drug and subject to the rebate, the discussion

above regarding Medicare rebates would apply to it.

Limits on the Ability of the

Government to Hold Down Prices

The federal government has tried often in the past

to restrain price growth, usually with mixed results.

A limited bureaucracy cannot successfully keep

track of and control the modern market. Prices in

the drug market are also very complicated; they

vary in many dimensions (dosage, form, and packaging, to name only three), any one of which could

be used to mask a price increase.

Given the hundreds of drugs and manufacturers

and the thousands of dosage and packaging forms in

the market, the federal agencies in charge of monitoring drug prices would have to rely on the compliance of the drug companies, as they largely do now

for the Medicaid rebate.

The Secretary of HHS may also operate under

substantial political constraints. New drugs are

20. For an analysis of the effects of the current Medicaid rebates, see

Institute for Pharmaceutical Economics, The Impact of Medicaid

Rebates on Gross Margins of Generic Pharmaceuticals (Philadelphia: Philadelphia College of Pharmacy and Science, July 1992).

typically introduced at prices higher than existing

drugs only when the new drugs offer some therapeutic advance. Once a drug is on the market for

six months—during negotiations—and has established

itself as a treatment, it would be difficult for the

Secretary to eliminate Medicare reimbursement and

force patients to pay more or do without, especially

if the drug in question does provide expanded therapeutic benefit. Without the threat of removing

Medicare reimbursement, however, the government

would have no leverage in negotiations.

The Cost Containment

Provisions in Perspective

The cost containment provisions of the Administration's proposal might be useful in reducing taxpayer

costs for the new benefits in Medicare, but they

would add administrative complexity, could have

substantial side effects, and might not reduce overall

pharmaceutical costs.

Spending on pharmaceuticals can be contained

by slowing the growth of prices or quantities or

both. The Administration's proposal focuses largely

on containing costs on the price side. But part of

the extraordinary increases in drug prices that have

been reported over the last few years may be a statistical illusion, a result of the way drug prices are

sampled and the price index is computed (see Box 1

in Chapter 2). Economists who have tried to correct

the government price indexes for these effects have

found that increases in brand-name drug prices,

though above general inflation, were less than official price measures indicated. Most important, generic drugs, which in unit terms represent a large

and increasing share of the prescription market,

have experienced virtually no price increases and

might actually be lowering average drug prices.

If price increases in pharmaceuticals have not

been as large as reported, the need for cost control

mechanisms may be less than previously thought.

Still, there may be a few drugs every year that provide unique capabilities but are very expensive.

And guaranteeing access to pharmaceuticals as part

of every resident's basic health coverage merits concern over costs. Given the political constraints,
CHAPTER FOUR THE REBATE ON MEDICARE PRESCRIPTION DRUGS 39

however, the proposed cost containment mechanisms might not be very effective at rolling back

such prices.

The drugs that could force Medicare and other

health plans to incur heavy expenses are those that

are taken regularly, perhaps daily, by large numbers

of people, but their price might not be high in absolute terms. It is difficult to determine in advance

which new drugs—including those now in clinical

trials—have the potential to impose higher costs on

Medicare and other plans. If used by enough people, even a drug that has a reasonable launch price

could be very expensive.

The increasing competition in the pharmaceutical market may also reduce taxpayer costs. Seventy

percent of all prescriptions are written for drugs that

are made by more than one company, and the percentage is expected to rise. The Administration's

proposal includes some market-oriented steps: for

example, the drug benefit in Medicare would increase competition by encouraging the use of generic drugs. Other fee-for-service benefit plans are

already going beyond such measures by using techniques that involve increasing competition, such as

employing companies that manage pharmacy benefits.

Chapter Five

Effects of Other Provisions

I

n addition to universal coverage, the Medicare

benefit, and the Advisory Council on Breakthrough Drugs, three other aspects of the

Administration's proposal would affect the pharmaceutical market directly:

o Restructuring the Medicaid program and ending

the rebate on Medicaid prescription drugs;

o Shifting more people to managed health care;

and

o Limiting the rate of growth of health insurance

premiums.

Changes in Medicaid

Under the Administration's proposal, the rebates

that pharmaceutical companies now pay to the government on all drugs purchased through Medicaid

would be repealed. Medicaid provides health coverage for some people who have very low incomes.

Under the Administration's proposal, direct Medicaid pharmaceutical benefits would be replaced with

subsidies of the premiums for low-income people

who obtained coverage through regional health alliances. Medicaid currently provides a generous

package of health benefits. All states provide drug

coverage but the generosity of the benefit varies.

Pharmaceutical manufacturers would no longer have

to pay the government a rebate on drugs purchased

by those people who were formerly covered through

Medicaid.

According to a recent Office of Technology

Assessment report, Medicaid covers 10 percent to

15 percent of all outpatient pharmaceutical expenditures.1

 The Medicaid rebates are equal to 15.7

percent of the average manufacturer's price or to the

best discount given by the manufacturer to an institutional purchaser, whichever is greater. The Medicaid rebates also increase if a drug's price rises

faster than the inflation rate. The Congressional

Budget Office found that 25 percent of the Medicaid rebate revenues in 1991 were paid on drugs for

which the best discount exceeded 15.7 percent. If

the Medicaid rebates were repealed, average unit

revenues of the pharmaceutical manufacturers could

increase by at least 2 percent (10 percent to 15

percent of 15.7 percent). This estimate does not

account for the instances in which the Medicaid

discount exceeds 15.7 percent; the estimate may

understate the rise in unit revenues for this reason.

However, if some of those who are now covered by

Medicaid move into plans that manage their drug

benefit (and therefore negotiate price discounts for

drugs with pharmaceutical firms), the estimate could

overstate the rise in average unit revenues. CBO

assumes that these two effects offset each other and

estimates that unit revenues on outpatient drugs

would rise by 2 percent if the Medicaid rebates

were repealed.

Shifting Patients to Managed

Care Providers

A managed care plan, such as a health maintenance

organization, may tend to use drugs more intensively than fee-for-service providers. If people

switch to managed care providers in large numbers

and if such providers continue to use pharmaceuticals as they have in the past, the market for drugs

Office of Technology Assessment, Pharmaceutical R&D: Costs,

Risks and Rewards (February 1993), p. 245.
42 HOW HEALTH CARE REFORM AFFECTS PHARMACEUTICAL RESEARCH AND DEVELOPMENT June 1994

could expand. CBO has not estimated how many

people would switch from fee-for-service to managed care providers as a result of the Administration's proposal.

Anecdotal evidence suggests that managed care

providers use more Pharmaceuticals than the average fee-for-service provider, even when demographic and other differences between the enrollees

are taken into consideration. Managed care providers, such as group or staff health maintenance organizations, which are at financial risk for the costs of

their patients' care, have a strong economic incentive to provide cost-effective treatments.

Because the number of managed care providers

has recently grown rapidly, there is little literature

dealing with their prescribing behavior. Nevertheless, one limited study has provided evidence consistent with the anecdotal observations.2

 This study

of one fee-for-service plan of a major corporation,

which included a prescription benefit, and seven

health maintenance organizations, which also included prescription benefits, revealed several differences in the behavior of the two types of plan toward Pharmaceuticals, namely:

o The health maintenance organizations prescribed

more drugs, even when differences in age profile were adjusted for.3

o Health maintenance organizations used more

generic drugs.

o The total cost of prescription drugs—both to the

plan and patient—was lower in health maintenance organizations than in fee-for-service

groups because generic drugs were used more

often. The health maintenance organizations'

total prescription costs were about 9 percent less

than the total prescription costs for fee-for-service groups for patients under 65.

2. Jonathan P. Weiner and others, "Impact of Managed Care on

Prescription Drug Use," Health Affairs (Spring 1991), pp. 140-

154.

3. Despite attempts to control for differences in population, substantial selection biases might occur in the two types of health plan.

o Health maintenance organizations began using

new Pharmaceuticals as rapidly as the fee-forservice providers. They reduced costs by substituting generics where possible, not by denying access to new drugs.

But these findings may have to be tempered

because the fee-for-service plan may not have had

typical benefits. In their review of the benefits, the

authors did not mention a deductible, which most

health plans have, although they did refer to a copayment, which most plans also have. The lack of

a deductible might have increased pharmaceutical

demand. Thus, the fact that these particular health

maintenance organizations had a lower spending

rate than this particular fee-for-service plan may

have been caused by both factors and was not simply a result of managed pharmaceutical benefits.

The study suggests that the number of prescriptions would rise as more persons moved to managed

care and that the primary beneficiaries of the increase would be manufacturers of generic drugs.

Manufacturers of brand-name pharmaceuticals might

benefit if they had a generic line of drugs, but their

nongeneric lines might suffer. In fact, brand-name

drug firms own many of the major generic drug

companies, which produce the majority of generic

drugs prescribed in this country.

Prescription drug use, however, is not the whole

story. Health maintenance organizations also have

lower rates of hospitalization than do fee-for-service

plans. Since hospitals use a major quantity of pharmaceuticals, the lower rate of hospitalization experienced by health maintenance organizations might

almost offset their greater use of outpatient prescription drugs. (These offsetting factors also serve to

illustrate the uncertainty surrounding the demand

estimates presented in the previous chapters.)

As managed care providers begin to occupy a

larger fraction of the market, fee-for-service providers may have to change their prescribing patterns.

Already the major health insurance plans encourage

their members to join a preferred provider organization, a form that uses some of the control mechanisms currently found in health maintenance organizations. And many of the indemnity health plans

have managed drug benefits.
CHAPTER FIVE EFFECTS OF OTHER PROVISIONS 43

Constraining the Rate

of Growth of Health

Plan Premiums

The Administration's proposal would set up a National Health Board, which would, among its other

duties, establish an initial target per capita premium

for the standard benefit package in each regional

health alliance.4 The board would also limit the

growth of the premiums. The weighted average

premium would be constrained to meet the target.

Each alliance would have a different target. CBO

has made no explicit estimate of the effect of this

provision on the pharmaceutical market.

Restraining the rate of growth of premiums

would probably shift medical practice toward less

expensive treatments, possibly including greater use

of Pharmaceuticals.5 If a plan is limited in the

growth of the premium that can be charged per person, the plan's sponsors would have every incentive

to reduce the costs of treatment, which often means

using drugs to substitute for more expensive forms

4. For corporations that had opted out of the regional alliance system, the board would only control the rate of growth. Similarly,

the board would also set per capita premium targets for states that

set up alternatives to the alliance system. For a fuller discussion

of the proposed National Health Board and the regional alliances,

see Congressional Budget Office, An Analysis of the Administration's Health Proposal (February 1994), pp. 22-24.

of medical treatment. The managed health care example, discussed in the previous section, seems to

point in this direction. Plans and providers would

be unlikely to do so in excess, however, because of

the development of practice guidelines.

Under the Administration's proposal, if the

weighted average premium in a regional alliance

was above the target, the National Health Board

could require plans with excessive premiums (according to criteria specified in the proposal) to

lower their premiums and their payments to providers.6

 The language is not clear about what would

happen to payments for prescription benefits, although they have not been explicitly exempted from

such cuts. Since pharmaceutical companies would

not be considered "participating providers," the

health plans would presumably not be able to reduce their incomes directly. The amount that the

plan paid per prescription might be lowered for

plans in which enrollees obtained their drugs from

retail pharmacists. Plans that have their own pharmacies or managed drug benefits might try contracting with drug wholesalers in the same way that they

would with participating providers; the contract

could specify that if the plan's premium were forced

down, wholesalers would have to accept a proportional reduction. Retailers and wholesalers, however, would in all likelihood attempt to pass back

any reductions in income to pharmaceutical manufacturers.

5. Ibid., pp. 74-76. 6. Ibid., pp. 22-23.

Chapter Six

The Effect of the Administration's

Proposal on the Returns from

Drug Development

W

hen a firm considers investing in the

development of new drugs, it weighs the

costs it expects to incur in the research

and approval process against the profits that the

drugs are likely to generate throughout their time on

the market. If the ventures are successful, the costs

incurred in drug discovery and development are exceeded by the profits generated by those drugs that

reach the market. If the changes proposed by the

Administration increase the returns from developing

new drugs, one would expect firms to invest more

in drug development.

The Administration's proposal contains a universal entitlement to a standard benefit package that

includes coverage for prescription drugs.1 If enacted, this universal coverage provision, together

with the changes in Medicare that the Administration proposes, would probably affect the average

returns from drug development positively, but only

slightly, when the average is taken of all types of

drugs. The proposed changes would increase the

returns on drugs that are marketed primarily to the

under-65 population and decrease the returns on

drugs that are marketed primarily to those who are

65 and over. When averaged over all drugs, the

increase in returns is so small that it would probably

not significantly affect the level of research and

development undertaken in the pharmaceutical industry.

What Previous Studies of

the Returns from Drug

Development Show

Two studies—by the Office of Technology Assessment and economists Henry Grabowski and John

Vernon-have compared the returns from developing

a new drug with the costs for drugs that were introduced in the United States in the early 1980s.2

Both studies found that the profits generated by a

new drug are generally more than sufficient to compensate for the cost of development, including the

cost of capital. But the amount by which returns

from developing a new drug exceed costs are modest, on average, and would be eliminated if the

average price received for drugs sold worldwide

were just 4.3 percent lower.

Both studies estimate that the average after-tax

cost of developing a new drug, including the cost of

capital, is about $190 million in 1990 dollars (see

Table 4).3 These cost estimates are based on a large

CBO's estimate of induced demand results from the combination

of a universal entitlement and a generous benefit package (offering

both comprehensive physician and drug coverage). For the sake

of brevity, this combination will be referred to as the universal

coverage provision of the Administration's proposal.

Office of Technology Assessment, Pharmaceutical R&D: Costs,

Risks and Rewards (February 1993); Henry Grabowski and John

Vernon, "Returns to R&D on New Drug Introductions in the

1980s" (paper presented at the American Enterprise Institute Conference on Competitive Strategies in the Pharmaceutical Industry,

Washington D.C., October 27-28, 1993).

Since research and development is treated for tax purposes as a

current expense, spending $1 more on R&D costs a company just

65 cents when the marginal tax rate is 35 percent. Before accounting for this tax savings, Grabowski and Vernon estimated

that it costs an average of $280 million to develop a new drug.
46 HOW HEALTH CARE REFORM AFFECTS PHARMACEUTICAL RESEARCH AND DEVELOPMENT June 1994

Table 4.

The Cost of Drug Development Compared

with Profits for the Average Drug

(In millions of 1990 dollars)

Estimates

Office of

Grabowski Technology

and Vemon Assessment

Average Profits (Returns)8 210 230

Average Research

and Development Costsb 188 194

Excess Profits0 22 36

SOURCE: Congressional Budget Office based on Office of

Technology Assessment, Pharmaceutical R&D:

Costs, Risks and Rewards, (February 1993), and

Henry Grabowski and John Vernon, "Returns to R&D

on New Drug Introductions in the 1980s" (paper

presented at the American Enterprise Institute Conference on Competitive Strategies in the Pharmaceutical Industry, Washington, D.C., October 27-28,

1993).

a. Present value of the profits generated from sales of the average drug over its product life.

b. Includes the cost of capital.

c. Equals average profits minus average research and development costs.

sample of drugs developed in the 1970s and marketed in the 1980s. They include investment in research and clinical tests to obtain Food and Drug

Administration approval as well as the cost of failures—that is, investment in research for drugs that

never made it to market.4 The cost of capital alone

constitutes approximately half of drug development

costs (see Appendix A).

Returns from drug development consist of the

present value of sales revenues less production, marketing, and administrative costs. The Office of

Technology Assessment estimated that the present

value of these profits would average $230 million;

Grabowski and Vernon's estimate is lower: $210

million.

Both studies found that the returns from developing a new drug exceed the costs. Grabowski and

Vernon calculated that the returns from developing

a new drug exceed the costs by an average of $22

million; OTA found that the returns exceed costs by

an average of $36 million in 1990 dollars (see Table

4). Although these estimates are relatively close,

the assumptions made in each study differ in several

important respects.5 On average, developing a new

drug yields returns greater than the amount required

to compensate investors for their cost of capital.

The excess profits, however, are modest. OTA

found that they would disappear if prices fell by an

average of just 4.3 percent worldwide (and the

quantity sold did not change).6 U.S. sales constitute

at most one-half of the worldwide sales of drugs

patented in the United States. Thus, a decline of at

least 8.6 percent in the average price of prescription

drugs in the United States would be necessary to

eliminate these excess returns if prices elsewhere

did not change.

Such estimates of excess returns are very sensitive to the cost of capital used to discount revenues

and capitalize costs.7 Increasing the cost of capital

lowers the present value of returns and increases the

present value of costs. Grabowski and Vernon point

out that excess returns would be eliminated in both

studies if the cost of capital were 1 percentage point

higher. By the same token, excess profits would be

higher-perhaps doubled-if the cost of capital were

1 percentage point lower.

4. Both studies base their cost estimates on the work of Joseph

DiMasi and others, "Cost of Innovation in the Pharmaceutical

Industry," Journal of Health Economics, vol. 10 (1991).

5. The cost of capital used in OTA's calculation of the cost of drug

development is higher than that used by Grabowski. OTA uses a

lower cost of capital than Grabowski in discounting profits. The

differences offset each other. Grabowski also uses a higher cost

for plant and machinery than does OTA.

6. Office of Technology Assessment, Pharmaceutical R&D, pp. 89-

90.

7. Both studies based their cost of capital on an OTA-commissioned

study that found the real cost of capital for this industry to be

between 10 percent and 11 percent. An alternative estimate suggests that the cost of capital could be lower. (See Appendix A.)
CHAPTER SIX THE EFFECT ON THE RETURNS FROM DRUG DEVELOPMENT 47

How the Returns from Drug

Development Would Change

The Administration's proposal affects the returns

from drug development by changing the quantity of

drugs that a company can expect to sell and the revenue it can expect to receive on each unit of a drug.

In analyzing the effect of the Administration's proposal on future returns from research and development, it is convenient to separate the pharmaceutical

market into two parts: that serving the under-65

population and that serving the 65-and-over population. In the Administration's proposal, the alliance

system covers almost all of those under 65, and

Medicare covers almost all of those who are 65 and

over. (The exceptions are that Medicare covers 1

percent of the under-65 population, and a small proportion of Medicare enrollees could choose to enroll

in a health plan through the alliance system.)

The Administration's proposal for universal

coverage would primarily affect the prescription

drug expenditures of those people who are under

65. The addition of a drug benefit to Medicare

would primarily affect those who are 65 and older.

Manufacturers would be required to pay at least a

17 percent rebate to the federal government on

outpatient Pharmaceuticals purchased by Medicare

enrollees. Since Medicare covers most of the 65-

and-over population, the rebate would reduce the

revenue received on drugs that are sold primarily to

this group. The universal coverage provision would

have its greatest effect on the demand for drugs by

extending coverage to the uninsured, 99 percent of

whom are under age 65. Most current Medicaid

beneficiaries would obtain coverage through regional alliances, and the Medicaid drug rebates

would no longer exist.

The Congressional Budget Office calculated the

effect of these provisions on the returns from drug

development using the sample of 67 drugs examined

by Grabowski and Vernon. The drugs were introduced in the United States between 1980 and 1984.

The sales data run through 1992; therefore, there

were only 8 to 12 years of actual sales data for

these drugs, depending on the year they were introduced on the market. Grabowski and Vernon projected sales after 1992 for each drug through its

product life of 20 years.

The returns on a drug equal the present value of

the profits it generates during its product life.

When demand for Pharmaceuticals rises, the change

in profits is equal to the increase in sales less the

cost of producing more units of the drug. The

increase in returns on a drug equal the discounted

value of this rise in profits in each year of the

drug's product life.8

Almost all of the changes in the demand for

prescription drugs, as well as those in the Medicare

rebate, would apply only to outpatient prescription

drugs, which constitute approximately 77 percent of

all sales of prescription drugs in the United States.

Also, these changes would affect only U.S. sales,

which both Grabowski and OTA have assumed

constitute one-half of all worldwide sales of the

drugs in their samples. Evidence suggests that the

U.S sales of patented drugs constitute somewhat less

than one-half of worldwide sales (see Chapter 2).

The sales of U.S. outpatient prescription drugs

therefore constitute less than 40 percent of the total

worldwide sales of drugs patented in the United

States (77 percent of 50 percent).

CBO assumed that for the purpose of these

calculations the cost of producing an extra unit of a

drug is equal to 25 percent of the drug's price.

This estimate of incremental costs is based on the

OTA study, which found that production and distribution costs were equal to 25 percent of sales. The

25 percent included the depreciation costs of the

manufacturing plant, which are not part of (variable)

unit costs. The cost of producing another unit of a

drug could therefore be below 25 percent of product

price. If demand is permanently increased, however, pharmaceutical companies would be likely to

increase their production capacity. Some adjustment

should therefore be made for this new capacity.

Using total plant depreciation clearly overstates the

8. The U.S. population is growing at a rate of about 1 percent a year.

Investment in new R&D projects today puts the average drug on

the market 12 years from now; however, the U.S. population will

be larger then. As the pharmaceutical market grows, the returns

from drug development will increase, all other factors being equal.

CBO did not take this effect into account in these calculations.
48 HOW HEALTH CARE REFORM AFFECTS PHARMACEUTICAL RESEARCH AND DEVELOPMENT June 1994

cost of this incremental capacity. The overstatement

might be justified, however, by arguing that some

small adjustment can be made for producers' increases in administrative or marketing costs when

responding to induced demand.

Other estimates of incremental (or marginal)

cost range between 17 percent and 34 percent of

product price (discussed further below). The results

presented in this chapter are not very sensitive to

variations of incremental cost within this range.

The Under-65 Population

The quantity of prescription drugs sold to the under65 market could increase by approximately 6 percent if the Administration's proposal for universal

coverage were enacted. Because of the uncertainties

involved in the induced demand calculations, CBO

has considered a wider range of induced demand

estimates in the sensitivity analysis section below.

For the base case, it is assumed that demand

under the universal coverage provision of the Administration's proposal would increase expenditures

for prescription drugs on the part of the under-65

population by 6 percent. The change in profits is

equal to a 6 percent increase in U.S. sales, minus

the cost of producing more units of the drug. An

examination of the discounted value of this increase

in profits over the product life of the drugs in the

sample (20 years) shows that when demand increases by 6 percent, the profits from developing a

new drug for the under-65 population could increase

by an average of $19 million (see Appendix B).

This amount constitutes an 8 percent increase in the

average profits from developing a drug.

Absorbing Medicaid into the alliance system

would eliminate the rebates that pharmaceutical

manufacturers are required to pay to the government

on all drugs purchased through Medicaid. A repeal

of this rebate would raise the average revenue per

unit of the drug sold on the outpatient market by 2

percent because Medicaid covers 10 percent to 15

percent of all outpatient pharmaceutical expenditures

(see Chapter 5). A 2 percent increase in unit revenue on outpatient drugs would yield an average

increase of $6 million in profits from drug development (see Appendix B). Thus, the repeal of the

Medicaid rebate would further increase the present

value of profits generated from marketing a drug by

an average of $6 million.

Together, these two effects imply that the Administration's proposal would raise the profits from

a drug developed exclusively for the under-65 population by an average of $26 million (see Table 5).

This amount constitutes an 11 percent increase in

the average present value of profits (returns) generated from marketing a drug. The increase is substantial, considering that it has been estimated that

average returns exceed R&D costs by just $22 million to $36 million.

The 65-and-Over Population

The proposal's new Medicare drug benefit could

increase the quantity of outpatient prescription drugs

sold to the 65-and-over population by approximately

4 percent (see Chapter 3). By itself, this change

would increase the profits from developing a new

drug for the 65-and-over population by an average

of $10 million. But the proposal would also require

that pharmaceutical manufacturers pay a 17 percent

rebate to the government on all outpatient drugs

purchased through Medicare. CBO estimates that a

rebate of 17 percent on all outpatient drugs paid for

by Medicare, together with the 4 percent increase in

outpatient demand, would reduce the returns on

drugs marketed to the 65-and-over population by an

average of $39 million (see Appendix B). This

would amount to a 17 percent decline in the average

returns from developing a drug, assuming that the

pharmaceutical manufacturers would not recover

any of the rebate by raising prices. If manufacturers

were able to offset some of this rebate by raising

prices, the decline in returns would be smaller.

Under the Administration's proposal, people

eligible for Medicare who are employed or married

to an employed worker would obtain their primary

coverage through an alliance rather than through

Medicare. CBO has estimated that in 1998, when

the Administration's proposal would become fully

operational nationwide, this change in coverage

would reduce the number of people who receive

primary coverage through Medicare by 2.5 mil-
CHAPTER SIX THE EFFECT ON THE RETURNS FROM DRUG DEVELOPMENT 49

Table 5.

The Effect of the Administration's Proposal on Average Profits from Developing a Drug: Base Case

Change in Average Profits

from Developing a Drug8

(In millions of 1990 dollars)

Administration's

Proposal

Universal

Coverage

Description

Coverage would be

extended to the

37 million uninsured,

almost all of whom are

under 65. Coverage

would improve for

another 9 percent

of the under-65

population.

Effect on the

Prescription Drug

Market

(Base-Case

Assumptions)

Expenditures by

the under-65

population on all

Pharmaceuticals

would rise by 6.4

percent.

Drugs

Purchased

Only by

People

Under 65

19

Drugs

Purchased

Only by

People

65 and Over

0

Drugs Purchased

Two-Thirds by

People Under 65,

One-Third by

People 65 and Over

(Market average)6

13

Medicaid

Becomes Part

of the Alliance

System

Drug Benefit

Added to

Medicare

Government would

fully subsidize

participation of

most Medicaid

recipients in the

alliance system.

Medicare would

cover outpatient

drugs. A rebate

of at least 17 percent would be imposed on outpatient

drugs purchased

through Medicare.

Medicaid rebates

would be eliminated.

Average unit revenues

on outpatient sales

would rise by 2

percent.

Expenditures by the

65-and-over population

on outpatient pharmaceuticals would rise

by 4.5 percent. Unit

revenues would decline

by 17 percent.

Total

J)

26

-39

-33

SOURCE: Congressional Budget Office.

a. Equals the change in the present value of profits generated from worldwide sales of the average drug over its product life. The calculations involved in preparing this table are explained in Appendix B.

b. On average, 34 percent of prescription drug expenditures can be attributed to people 65 and over. This column equals 66 percent of

column 3 plus 34 percent of column 4.

lion.9 Since 0.7 million of these people would be

disabled, by 1998 the number of 65-and-over Medicare enrollees would fall by about 1.8 million-an

approximate 5 percent decline in the number of 65-

9. Congressional Budget Office, An Analysis of the Administration's

Health Proposal (February 1994), p. 34.

and-over Medicare enrollees (below what it would

have been without this provision). This decline in

the proportion of the 65-and-over population that

would be covered through Medicare was accounted

for in the above calculation.

In 1987, Medicaid covered 9 percent to 10

percent of the outpatient prescription drug expen-
50 HOW HEALTH CARE REFORM AFFECTS PHARMACEUTICAL RESEARCH AND DEVELOPMENT June 1994

ditures for both the under- and over-65 populations.10

 Thus, the repeal of the Medicaid rebate

would affect the 65-and-over market much as it did

the under-65 market. The returns from drugs developed primarily for those who are 65 and over

should also increase by an average of $6 million.

After accounting for the increase in average price,

which would occur as the Medicaid rebates are

repealed, returns from a drug developed for the 65-

and-over population would fall by an average of

$33 million (see Table 5). This net amount is a

decline of 14 percent in the average returns from

developing a drug. The decline would nearly eliminate excess returns as measured by OTA and would

exceed excess returns as measured by Grabowski.

A decline in the returns from developing drugs

for the 65-and-over population would reduce the

manufacturers' incentive to develop them and could

result in a decline in the level of research into drugs

used primarily by the 65-and-over population. If

that happened, research projects that were expected

to be the least profitable would be dropped first. If

the level of research into drugs aimed at the 65-andover population were reduced, the projects that were

undertaken would on average become more profitable. Most drugs that previously appeared profitable to develop for the 65-and-over population

might still seem profitable.

The Full Market-Over and Under 65

When averaged among all drugs, returns from R&D

would rise slightly under the Administration's proposed changes. Returns from those drugs sold primarily to people 65 and over would fall, and those

from drugs sold mostly to the under-65 population

would rise. But few drugs are marketed exclusively

to either population. The 65-and-over population

consumes approximately one-third of all prescription

drugs. When averaged among all drugs, the change

in returns from drug development is equal to onethird of the change in returns calculated for the 65-

and-over market, plus two-thirds of the change in

returns calculated for the under-65 market. Thus,

returns from drug development, averaged among all

drugs, could rise by $6 million under the changes

proposed by the Administration (see Table 5). The

change is small-equal to less than 3 percent of total

estimated returns from drug development.

Although these changes in the over- and under65 markets nearly balance out when returns are

averaged among all drugs, they may affect the types

of research projects that are undertaken. The returns from developing drugs primarily for those 65

and over would decline, whereas the returns from

developing a drug for the under-65 market would

rise. Although illnesses do not typically strike only

the 65-and-over population, the prevalance of certain health problems is disproportionately high

among this age group. People over 65 account for

an extremely large share of the market for drugs to

treat such disorders as prostate ailments, osteoporosis, and Alzheimer's disease. In other instances,

they represent a large but not overwhelming share

of the potential market; for example, doctors report

that more than 55 percent of their prescriptions for

cardiovascular drugs are written for people over

65.n Their larger than one-half share alone appears

to be sufficient to change the Administration's proposal from a modestly positive net influence on

returns to a negative one for these drugs (see Figure

9).

If two-thirds of a drug's potential market consists of people 65 and over, average returns would

fall by $13 million. This decline would be eliminated if the Medicare rebate were reduced from 17

percent to 10 percent. Under the Administration's

proposal, if half of the potential market for a drug

consists of people over 65, average returns would

drop by $4 million. This decrease is equal to less

than 2 percent of the average returns from developing a drug.

10. Office of Technology Assessment, Pharmaceutical R&D, p. 240.

The rate of expansion of under-65 Medicaid enrollees may have

exceeded that of 65-and-over Medicaid enrollees since 1987.

11. Doctors' reports may differ from their actual prescriptions. The

percentage represents the weighted average among several categories of coronary drugs. IMS America, National Disease and Therapeutic Index, U.S. Drug Store and U.S. Hospital Audits (Plymouth Meeting, Pa.: IMS America, Ltd., 1994).
CHAPTER SIX THE EFFECT ON THE RETURNS FROM DRUG DEVELOPMENT 51

Figure 9.

How the Change in Average Returns from

Developing a Drug Under the Administration's

Proposal Varies as the Share Consumed by

People 65 and Over Increases

40

20

Millions of 1990 Dollars

-20

-40

Market Average

Change in

Average Returns

20 40 60 80

Percentage Consumed by 65-and-Over Population

100

SOURCE: Congressional Budget Office.

NOTE: On average, people 65 and over consume 34 percent of

prescription drugs.

If research can be sufficiently targeted, this

difference in returns by age category could cause

some shift in research away from outpatient drugs

for the 65-and-over population toward drugs developed primarily for the under-65 population. The

shift may be small, however, and is not estimated.

Sensitivity of the Results to

the Base-Case Assumptions

Given the uncertainties surrounding the estimates of

induced demand and the effect of the Medicare

rebate agreement on the price of new drugs, CBO

changed the base-case assumptions to assess the

degree to which these results could vary. The base

case assumes that marginal cost would be equal to

25 percent of the unit price and that if the Administration's proposal were enacted:

Universal coverage would increase all prescription drug expenditures of the under-65 population by 6 percent, and the Medicare drug benefit

would increase all prescription drug expenditures of the 65-and-over population by 4 percent;

The resulting Medicare rebate would effectively

lower unit revenues (the per-unit manufacturer's

price less the rebate) by 17 percent on drugs

purchased by Medicare enrollees;

The repeal of the Medicaid rebate would increase unit revenues on outpatient prescription

drugs by 2 percent; and,

There would be no further erosion of sales

caused by generic competition after patent expiration.

Changes in Demand

Based on the sales data of Grabowski and Vernon's

sample of 67 drugs, every 1 percent increase in

demand for pharmaceuticals in the United States

would increase the net returns from the average

drug by approximately $3 million after taxes (see

Appendix B). The base-case estimates of induced

demand are somewhat conservative; even so, the

base case predicts a slight increase in returns from

R&D under the Administration's proposal. If the

assumptions were even more conservative, however,

and demand growth were 50 percent below that

assumed in the base case, the effect of the universal

coverage provision and the Medicare drug benefit

on average returns from drug development would

still be small, lowering average returns by just $2

million (see Table 6). If the induced demand estimates were doubled, average returns would increase

by $21 million, an 8 percent increase in the total

returns from the average drug and a more than 50

percent increase in excess returns.

Incremental Costs

The base case assumes that the marginal or incremental cost of producing one more unit is equal to
52 HOW HEALTH CARE REFORM AFFECTS PHARMACEUTICAL RESEARCH AND DEVELOPMENT June 1994

Table 6.

The Effect of the Administration's Proposal on Average Profits from Developing

a Drug Under Varying Assumptions About Induced Demand (In millions of 1990 dollars)

Population Under 65:

The Effect of

Universal Coverage8

Base Case

Demand 50 Percent Higher

Demand 100 Percent Higher

Demand 50 Percent Lower

Assumed

Change in

Demand0

(Percent)

6

10

13

3

Effect on

Average

Profits

19

29

39

10

Population Over 65:

The Effect of

Changes to Medicare

Assumed

Change in

Demand0

(Percent)

3

e

5

7

2

Effect on

Average

Profits

-39

-35

-31

-43

Market Average6

Assumed

Change in

Demand

(Percent)

5

8

11

3

Effect on

Average

Profitsd

6

13

21

-2

SOURCE: Congressional Budget Office.

a. Universal coverage here refers to a universal entitlement to the standard benefit package proposed by the Administration. It includes a

prescription drug benefit.

b. Averaged over all drugs, based on 34 percent of prescription drugs sold to those 65 and over and 66 percent of prescription drugs sold

to those under 65.

c. The percentage increase in prescription drug expenditures (both inpatient and outpatient).

d. Equals 66 percent of column 2 plus 34 percent of column 4 plus $6 million (for repeal of the Medicaid rebates).

e. Outpatient drug expenditures are assumed to rise 4.5 percent in the base case for this group. Since outpatient drugs constitute 77

percent of prescription drug sales, total expenditures for this group would rise by 3.4 percent (77 percent of 4.5 percent).

25 percent of the product price. A lower estimate

of incremental costs comes from the work of economists Richard Caves, Michael Whinston, and Mark

Hurwitz, which shows that the price of generic

drugs, after sufficient generic entry, amounts to 17

percent of the price of the brand-name drug against

which they compete.12 This ratio can be considered

12. Richard Caves, Michael Whinston, and Mark Hurwitz, "Patent

Expiration, Entry, and Competition in the U.S. Pharmaceutical

Industry," Brookings Papers on Economic Activity: Microeconomics, 1991 (1991). The generic price is estimated to be 17 percent

of the brand-name price before patent expiration and generic entry.

In addition, Henry Grabowski and John Vernon estimated the

marginal cost of a patented drug to be 21 percent of product price.

See "Brand Loyalty, Entry and Price Competition in Pharmaceuticals after the 1984 Act," Journal of Law and Economics (October

1992).

an estimate of marginal cost because the unit costs

of producing a generic drug should be similar to

those of producing a brand-name drug. By contrast,

the Census of Manufactures reports that material

and production-labor costs constituted 34 percent of

the value of drug shipments in 1987. But this ratio

probably overstates the share of incremental costs,

since the census includes over-the-counter drugs,

which are likely to have lower markups.13

The base-case results are not very sensitive to

the marginal cost assumption (see Table 7). The

13. Bureau of the Census, 7957 Census of Manufactures, Industry

Series, Drugs (April 1990), Table la-1.
CHAPTER SIX THE EFFECT ON THE RETURNS FROM DRUG DEVELOPMENT 53

results do not change substantially for incremental

costs that range between 17 percent and 35 percent

of prescription drug prices. Even if the marginal

cost were equal to 40 percent of a drug's price, the

returns from the average drug would still rise

slightly under the Administration's proposal.

Changes in New Drug Prices

If pharmaceutical companies, by raising the prices

of new drugs, can offset some of the revenue they

would lose because of the rebate, the returns from

the development of a drug for the 65-and-over population would decline by less than $33 million.

This offset could occur if manufacturers increased

the launch prices of new drugs and the Secretary of

Health and Human Services did not increase the

Medicare rebate. It is not known, however, whether

launch prices would be higher or lower as a result

of the Medicare rebate agreement. The larger the

proportion of a drug's market that belongs to Medicare enrollees, the greater is the Secretary's power

to influence the drug's price. The base case asTable 7.

The Effect of the Administration's Proposal on Average Profits from Developing

a Drug Under Varying Assumptions About Marginal Cost (In millions of 1990 dollars)

Marginal Cost

as a Percentage

of Product Price

Population

Under 65:

The Effect of

Universal

Coverage on

Average Returns8

Population

Over 65:

The Effect of

Changes to

Medicare on

Average Returns

Market

Average

Change

in Profits5

Base Case 25 19 -39

Marginal Cost

8 Percentage

Points Lower 17 21 -38

Marginal Cost

5 Percentage

Points Lower 20 21 -38

Marginal Cost

5 Percentage

Points Higher 30 18 -40

Marginal Cost

10 Percentage

Points Higher 35 17 -41

Marginal Cost

15 Percentage

Points Higher 40 16 -41

7

7

4

3

2

SOURCE: Congressional Budget Office.

a. Universal coverage here refers to a universal entitlement to the standard benefit package proposed by the Administration. It includes a

prescription drug benefit.

b. Averaged over all drugs, based on 34 percent of prescription drugs sold to those 65 and over and 66 percent of prescription drugs sold

to those under 65. Change equals 66 percent of column 2 plus 34 percent of column 3 plus $6 million (for repeal of the Medicaid

rebates).
54 HOW HEALTH CARE REFORM AFFECTS PHARMACEUTICAL RESEARCH AND DEVELOPMENT June 1994

Table 8.

The Effect of the Administration's Proposal on Average Profits from Developing

a Drug for the 65-and-Over Population Under Variying Assumptions About Producer Price

Percentage Change

in Producer Price*

Precentage Change

in Unit Revenue

When Combined

with the Rebateb

Change in Average Returns0

(In miilions of 1990 dollars)

Assuming

Quantity Sold Assuming Quantity

Does Not Change Sold Changes*

Base Case

Price 5 Percent Higher

Price 10 Percent Higher

Price 5 Percent Lower

Price 1 0 Percent Lower

0

5

10

-5

•10

-17

-13

-9

-21

-25

-33

-15

4

-51

-70

-33

-18

-4

-48

-62

SOURCE: Congressional Budget Office.

a. This percentage change in producer price is assumed to hold throughout the product life of the drug.

b. Equals column 1 minus 17 percentage points minus 17 percent of column 1.

c. Includes $6 million for the repeal of the Medicaid rebates. The calculations are explained in Appendix C.

d. Assumes that for every 1 percent increase (or decrease) in price the quantity sold falls (or rises) by 0.3 percent.

sumes that pharmaceutical companies are not able to

circumvent the rebates by raising prices. If negotiations over the size of the rebate did not prevent

drug prices from rising, returns could fall by less

than 14 percent on drugs developed for the 65-andover population. If these negotiations were to result

in lower drug prices, returns could fall even farther.

The base case assumes that the Medicare rebate

agreement does not affect prescription drug prices.

In the base case, the changes proposed in Medicare

would lower the returns from drugs developed for

the 65-and-older population by $33 million. If, in

addition, the prices of these drugs were lowered by

an average of 10 percent throughout their product

lives (and the rebate remained at 17 percent), returns could fall by up to $62 million on drugs sold

only to the 65-and-over population (see Table 8).14

14. For these calculations, CBO assumes that demand is relatively

unresponsive to price changes (specifically, for a 1 percent increase in price the quantity purchased declines by just 0.3 percent). See Appendix B for an explanation of the calculations.

This fall would represent a 27 percent decline in

average returns from drugs developed for the 65-

and-over population. Conversely, if a drug's price

were raised by 10 percent, and the rebate remained

at 17 percent, the returns on drugs developed for the

65-and-over population could fall by just $4 million.

The change in returns on drugs developed primarily

for the 65-and-over population depends critically on

the effect of the Medicare rebate agreement on the

prices of new drugs used intensively by Medicare

enrollees.

Competition from Generic Drugs

The present discounted value of U.S. sales used in

these calculations was obtained from Grabowski and

Vernon's sample of 67 new drugs introduced between 1980 and 1984. Since the sales data run only

through 1992, there were only 8 to 12 years of actual information about each drug. Most drugs in the

sample have effective patent lives of 9 to 13 years.

Grabowski and Vernon projected the U.S. sales of
CHAPTER SIX THE EFFECT ON THE RETURNS FROM DRUG DEVELOPMENT 55

each drug through a 20-year product life. Based on

their previous work, the authors assumed that sales

declined by 30 percent in the first year after patent

expiration, 21 percent in the second, and 20 percent

during the final four years. In the remaining years

after patent expiration, they assumed sales would

erode at a rate of 10 percent to 12 percent.15

The Medicare drug benefit would provide incentives for enrollees to choose generic substitutes

when available. The proposal might also encourage

a higher rate of substitution of generic drugs by the

under-65 population. In the U.S. sales data used in

the base case obtained from Grabowski and Vernon,

it is assumed that five years after patent expiration,

sales of the name-brand drug have eroded to just 38

percent of the value they had in the year before expiration. Grabowski and Vernon have estimated

that if the generic erosion rate were increased by 50

percent, average net returns would decline by $19

million.16 An OTA-commissioned study of 35

drugs that lost patent protection between 1984 and

1987 found that three years after patent expiration,

sales were still at 83 percent of the level they had

attained before patent expiration. OTA found that

an erosion rate of more than 30 percent a year in

each year after patent expiration would be necessary

before returns would fall by $36 million, eliminating the excess returns from drug development.

Conclusions

If the changes proposed by the Administration were

to increase the returns from drug development, in15. Grabowski and Vernon, "Brand Loyalty, Entry and Price Competition in Pharmaceuticals after the 1984 Act."

16. Henry Grabowski and John Vernon, "Returns to R&D on New

Drug Introductions in the 1980s" (paper presented at the American

Enterprise Institute Conference on Competitive Strategies in the

Pharmaceutical Industry, Washington, D.C., October 27-28, 1993).

vestment in new drugs would most likely rise.

When averaged among all drugs, returns would

increase slightly under the Administration's proposal. Returns from drugs developed mostly for the

65-and-over population, however, would decline,

and the returns from developing drugs primarily for

those under 65 would increase.

Previous studies have found that the returns

from developing a new drug exceed the cost of

development by an average of $22 million to $36

million. The Administration's proposal for universal

coverage (including a drug benefit), together with a

repeal of the Medicaid rebates, could increase the

returns from developing a drug for the under-65

population by $26 million. The returns from developing a drug for the 65-and-over population would

be affected by Medicare's new drug benefit, the

new 17 percent Medicare rebate, and the repeal of

the Medicaid rebate. CBO estimates that together

these provisions in the Administration's proposal

could reduce the returns from developing a drug for

the 65-and-over population by $33 million.

The general level of R&D in the pharmaceutical

industry may not change much as a result of these

provisions because the returns change little when

averaged among all drugs. However, the difference

in returns by age category could cause an increase

in research into drugs aimed primarily at the under65 market and a slight decline in research into drugs

aimed primarily at the 65-and-over market.

It is not known whether the launch price of a

new drug would be higher or lower as a result of

the Medicare rebate agreement. The more frequently a drug is purchased by Medicare enrollees,

the greater is the Secretary's power to influence the

drug's price. If the Medicare rebate agreement

results in lower prices of new drugs used intensively

by the over-65 population, the returns from developing drugs primarily for this population could decline

further.

Chapter Seven

Conclusions

A

review of the major provisions for pharmaceutical coverage in the Administration's

health care proposal indicates that, on average, the returns from drug company research and

development would be unlikely to change; increases

resulting from one provision would wash out the

decreases resulting from another. The incentive

system facing pharmaceutical companies would

probably shift, however. Individual parts of the

drug market would be affected in different ways and

in different directions, perhaps inducing pharmaceutical companies to shift their resources. But all of

these results would depend crucially on how the

pharmaceutical companies responded to the Medicare rebate agreement.

Clearly, the major direct vehicle in the Administration's proposal for containing pharmaceutical

prices and costs would be Medicare's rebate on

prescription drugs. Although other provisions also

attempt to control costs, their effects would be

indirect or diffuse. Because drugs are such a small

part of total health care spending, the limits on the

rate of growth of insurance premiums would be

unlikely to inhibit drug prices substantially, especially if providers increase their use of drugs to

substitute medicinal treatments for surgical procedures. The effect of the Advisory Council on

Breakthrough Drugs might be limited to only a few

drugs each year. Moreover, aside from its potential

influence on Medicare rebate negotiations, it would

at best have the power to make recommendations

and sway public opinion. Public opinion has

brought some drug prices down, especially when it

has already been mobilized-as in the case of some

drugs used to treat human immunodeficiency virus

infection-but has failed in other cases.

In view of increasing competition within the

pharmaceutical market, drug prices could easily

decrease regardless of the Administration's proposal.

The forces already at work will serve to reduce, but

probably not eliminate, whatever excess profits exist

in the industry. Given the reduced potential for

profitable investment, R&D may (and perhaps

should) decrease. But if the practice of medicine is

going to change toward an emphasis on more costeffectiveness, the use of pharmaceuticals is likely to

rise independently of other factors in the pharmaceutical market or the Administration's proposal.

The reader should be reminded of the uncertainty surrounding the work of the Congressional

Budget Office in this instance. The tools that economists use work best with marginal changes, but the

contemplated changes are not marginal. Consequently, although CBO has tested its conclusions

to see if they are valid in several dimensions, substantial imprecision remains.

The tensions and trade-offs discussed here go

beyond the Administration's proposal. Any health

care reform proposal that provides a prescription

drug benefit and expands the market will provide

more incentives for pharmaceutical R&D. Proposals

to contain the costs of drugs will reduce these incentives. CBO's estimate suggests that the Administration's proposal balances these two aspects

almost exactly, but other plans may not do so.

Incentives Provided by the

Medicare Rebate

Viewed in isolation, the Medicare rebate would

provide pharmaceutical companies with many incentives to reduce their R&D on prescription drugs for

the 65-and-over segment of the market, insofar as

such specialized drugs can be identified. The proposed rebate of at least 17 percent would reduce the
58 HOW HEALTH CARE REFORM AFFECTS PHARMACEUTICAL RESEARCH AND DEVELOPMENT June 1994

returns on new drugs that are aimed largely at the

65-and-over market. For example, the returns from

some cardiovascular medicines could be lowered

slightly by the rebates because of the large number

of 65-and-over consumers. Furthermore, the returns

from drugs developed for the under-65 population

would increase. This difference in returns on the

basis of age group may cause some R&D to be

shifted away from drugs targeted at people who are

65 years old and older, toward those pharmaceuticals aimed at younger people.

Medicare would impose additional rebates if

price increases rose above changes in the consumer

price index. New drugs, breakthrough or not, could

face a special rebate if their introductory or launch

price was judged too high, further lowering the

profit incentive. All of these additional provisions

are designed to ensure that pharmaceutical producers would absorb most, if not all, of the rebate from

their profits.

The Medicare rebate would probably provide a

different set of incentives than the Medicaid rebate.

Whereas Medicaid beneficiaries are distributed

throughout the population-indeed, poverty is the

only common denominator—Medicare beneficiaries

are concentrated in older age groups. And they

dominate numerically the age groups in which they

are concentrated, making up 90 percent of the 65-

and-over population. Moreover, the portion of the

market affected by a Medicare rebate is twice the

size of that currently affected by the Medicaid rebate.

The Medicare program, however, would not

operate^ in a political or economic vacuum. Politically, it would be difficult for Medicare to deny

coverage for a drug that treats a major illness successfully, regardless of the outcome of rebate negotiations with the manufacturer. Furthermore, the

market for most drugs is not perfectly segregated by

age; therefore, the rebate would affect only a portion of the sales of each drug. Manufacturers may

be able to recover part of their rebate costs from

other sales by raising their prices.

The well-known serendipity of the R&D process

is also likely to operate in this context. Companies

not looking for treatments for conditions that mainly

affect persons 65 and older could discover such

treatments while searching for others. This serendipity is less likely now, given the costs and complexity of drug development and clinical testing.

Quite often, however, drugs developed to treat one

illness become widely used for other purposes.

In the context of all of these mitigating factors,

the analyses in previous chapters should not be

interpreted as meaning that there would be few new

drugs developed for the 65-and-over market. There

are too many counteracting factors to support that

strong a conclusion. But the more successful health

authorities are in making pharmaceutical producers

absorb the cost of the rebate, the less incentive

producers would have to produce drugs for this

market. By contrast, the less successful health

authorities are in making the pharmaceutical companies absorb the rebate, the more other drug consumers would pay to support Medicare drug benefits.

The Changing Pharmaceutical

Market

The Administration's proposal takes advantage of

favorable trends in the pharmaceutical market. The

increased pressure on drug producers noted in previous chapters fits with the Administration's general

theme of encouraging more competition among

health care providers. Specific provisions of the

Administration's proposal, such as encouraging

greater use of generic drugs by Medicare beneficiaries, also incorporate some of the techniques that are

being used by managed care providers to control

costs. Although they take occasional advantage of

the general trend in the pharmaceutical market towards increased competition, some provisions that

reduce Medicare costs, such as special rebates on

new drugs, may serve to discourage the development of rival drugs.
Appendixes

Appendix A

The Cost of Capital

T

he cost of capital is a large component of

the total cost of introducing a new drug. It

takes an average of 12 years to develop a

drug and obtain Food and Drug Administration

approval. Grabowski and Vernon capitalized research and development (R&D) investment at a real

interest rate of 10.5 percent.1 Since investment in

drug development in its early stages is more risky

than in its later stages, the Office of Technology

Assessment (OTA) varied the discount rate over

time, beginning at 14 percent and declining linearly

to 10 percent as market introduction approaches.2

The resulting discounted value of R&D costs was

higher than if a constant discount rate of 10.5 percent had been used. If $10 million (valued in 1990

dollars) is invested in a drug during the first year,

the cost of that investment, capitalized to the year of

market introduction, is $33 million (in 1990 dollars)

at a real interest rate of 10.5 percent. In both studies, the cost of capital alone accounts for about half

of the total cost of developing a new drug (capitalizing costs to the year of market introduction).

OTA commissioned a study of the cost of capital for the pharmaceutical industry in 1990. The

study found that the cost of equity capital for 17 of

the largest pharmaceutical companies, adjusted for

inflation, was between 10 percent and 11 percent.3

 This real cost of capital appears to be high

because inflation has already been deducted. It is

based on previous returns to equity investors, which

depend on after-tax corporate profits. And it includes a risk premium associated with the nondiversifiable risk for equity investors in the pharmaceutical industry. Nondiversifiable risk includes

both the risk arising from swings in the entire economy and the risk that a firm cannot eliminate by

investing in many projects.

OTA's estimate of the cost of capital is based

on the capital asset pricing model. According to

this model, the cost of equity capital is the sum of a

risk premium (based on the stock market risk premium for investors in corporate equities estimated at

a nominal rate of 8.7 percent in 1990) plus a riskfree rate (6.8 percent in 1990, according to the

study). The risk premium associated with the pharmaceutical stocks is estimated to be 98 percent of

the stock market risk premium in 1990. After adjusting for inflation expectations in 1990, the real

cost of equity capital for this industry was estimated

at 10.4 percent. By contrast, if the risk premium

calculated by G. Bennett Stewart were used, the

cost of capital would be about 1 percent lower than

that projected in the study OTA commissioned.4

Henry Grabowski and John Vernon, "Returns to R&D on New

Drug Introductions in the 1980s" (paper presented at the American

Enterprise Institute Conference on Competitive Strategies in the

Pharmaceutical Industry, Washington, D.C., October 27-28, 1993).

Office of Technology Assessment, Pharmaceutical R&D: Costs,

Risks and Rewards (February 1993).

4.

Ibid., p. 278. Stewart C. Myers and Lakshmi Shyma-Sunder did

the study.

G.B. Stewart, The Quest for Value (New York: Harper Collins

Publishers, Inc., 1991), and Office of Technology Assessment,

Pharmaceutical R&D, p. 281.

Appendix B

Calculating the Change in Average Returns

from Drug Development

T

his appendix presents the method of calculating the changes in average returns from

drug development under the Administration's proposal. The results of the first three calculations are summarized in Table 5 in Chapter 6.

1. Universal coverage under the Administration's

proposal would increase the average profits on

drugs sold to the under-65 population by $19 million (in 1990 dollars). The change in average returns on drugs sold to the under-65 population is

equal to the increase in prescription drug sales

caused by the universal coverage provision, less the

cost of producing more units of the drugs.

The calculation:

$19 = [0.064 - (0.064)(0.25)]($621)(0.65)

where:

0.064 = the percentage increase in prescription

drug sales to the under-65 population under the

universal coverage provision,

0.25 = unit variable cost as a percentage of

product price,

$621 = the present discounted value of U.S.

sales at a real interest rate of 10.5 percent, in

millions of 1990 dollars, and

0.65 = (1 - the marginal tax rate of 35 percent).

2. Under the Administration's proposal, the Medicaid rebates would be repealed. The Medicaid rebate

is equal to 15.7 percent of the average manufacturer

price or the best discount given to institutional

purchasers, whichever is greater (see Chapter 5).

Given that the rebate covers 10 percent to 15 percent of the entire outpatient prescription drug market, outpatient unit revenues would increase by

about 2 percent if this rebate is repealed.

The calculation:

0.016 = (0.157)(0.10) or 0.023 = (0.157)(0.15)

Assuming that the repeal of the Medicaid rebate

would increase outpatient unit revenues by 2 percent, it follows that the profits from developing a

drug would increase by $6 million on average.

The calculation:

$6 = (0.02)($621)(0.77)(0.65)

where:

0.02 = percentage increase in outpatient unit

revenues when the Medicaid rebate is repealed;

0.77 = the proportion of prescription drug sales

that are outpatient.

3. The Medicare rebate, combined with the proposed drug benefit, would reduce the returns on

drugs sold to the 65-and-over population by $39

million. This change is equal to the increase in

demand caused by Medicare's new drug benefit less

the cost of producing the extra output, less the

rebate of 17 percent paid on all drugs sold to 65-

and-over Medicare enrollees.
64 HOW HEALTH CARE REFORM AFFECTS PHARMACEUTICAL RESEARCH AND DEVELOPMENT June 1994

The calculation:

-$39 = [0.043-(0.17)(0.95)-(0.17)(0.043)(0.95)-

(0.25)(.043)]($621)(0.77)(0.65)(0.946H[0.0041-

(0.25)(0.0041)]($621)(0.77)(0.65)

where:

0.043 = estimated increase in outpatient prescription drug expenditures of 65-and-over

Medicare enrollees due to the Medicare drug

benefit;

0.17 = 17 percent rebate paid on all outpatient

drugs purchased through Medicare;

0.95 = the percentage of the current Medicare

population that will pay the 17 percent rebate.

Under the Administration's proposal the Medicare population would decline by 5 percent

when those with working spouses receive health

coverage through their spouses rather than

through Medicare. This does not affect the

induced demand calculation since these people

still receive a drug benefit. However, the Medicare rebate will apply to a smaller portion of the

population that is 65 and over.

0.946 = the portion of the 65-and-over outpatient market that would be covered by

Medicare's new drug benefit. According to the

Health Care Financing Administration, there

were 29.7 million enrollees in Medicare's Supplementary Medical Insurance (SMI) program in

1990 over age 65. This number includes some

non-U.S. residents. There were 0.3 million nonU.S. residents enrolled in SMI in 1990. Thus,

the total U.S. resident population of those who

are 65 years old or older who enrolled in SMI

in 1990 was about 29.4 million. Since there

were 31.08 million U.S. residents 65 or older in

1990, it follows that approximately 94.6 percent

of U.S. residents age 65 or older were enrolled

in SMI.1

Health Care Financing Administration, Medicare and Medicaid

Statistical Supplement (1992), pp. 14, 18-19, and Bureau of the

Census, Statistical Abstract of the U.S., 1993, p. 21.

0.0041 = the increase in prescription drug expenditures of the 65-and-over population, caused

by physician and drug coverage for the uninsured in this age group. It is assumed that the

drug coverage would be received through the

alliance system (thus, no rebate is paid on the

0.4 percent increase in expenditures). Actually,

the uninsured in this age group could be covered either by the alliance system or by Medicare. However, since this group is so small, the

assumption has little effect on the result.

The increase in outpatient prescription drug expenditures of the 65-and-over population that lies behind this calculation is 4.5 percent.

The calculation:

0.045 = (0.043)(0.946) + 0.0041

4. It is stated in Chapter 6 that for every 1 percent

increase in the quantity of prescription drugs sold,

the average profits from developing a drug would

rise by $3 million (after taxes).

The calculation:

$3 = [0.01 - 0.25(0.01)]($621)(0.65)

The change in returns is equal to a 1 percent increase in sales less the cost of producing 1 percent

more units of the drug (less the taxes on this extra

revenue).

The average U.S. sales of a drug during its

product life used in CBO's calculations appear to be

similar to those used by the Office of Technology

Assessment (OTA) in its study on total returns from

research and development in the pharmaceutical

industry. Based on OTA's calculations, a decline of

8.6 percent in the U.S. price of all prescription

drugs would reduce average returns by $36 million

(eliminating the excess returns from drug development, assuming that the quantity sold does not

change). According to the U.S. sales data used in

the above calculations, a decline of 8.8 percent in

the U.S. price is required to reduce returns by $36

million. This difference of just 0.2 percent indicates

that the present value of U.S. sales used here is

close to that obtained by OTA.
Appendix C

Sensitivity of Profit Calculations to

Product Price Changes

T

his appendix explains how the returns from

drugs developed for the 65-and-over population change when product price varies. The

results are summarized in Table 8 in Chapter 6. It

is assumed that the price change occurs throughout

the drug's product life on both inpatient and outpatient sales. The Medicare rebate is only paid on

outpatient drugs and is assumed to remain at 17

percent.

Equations (1) and (2) estimate the change in

average returns to drugs developed for the over-65

population under the Administration's proposal

when, as a result of the Medicare rebate agreement,

pharmaceutical firms change drug prices. Equation

(1) assumes that the quantity sold does not change

when price changes, but equation (2) allows for

some adjustment in the quantity sold for a given

change in price.

1. No change in the quantity purchased (Column 3

of Table 8).

Ap = the percentage change in product price

Change in returns =

-33 + Ap[(621)(0.65)(0.77)(1.045)]

-Ap[(0.17)(0.946)(0.95)(0.77)(621)(0.65)

•(1.043)] + Ap[(621)(0.65)(0.23)]

The first term is the change in returns in the

base case. The second term is the increase in revenues that occurs when a higher price is charged on

the outpatient market. (See Appendix B for an

explanation of each number.) The third term is the

increase in the Medicare rebate when the price is

raised. The fourth term is the increase in revenues

when a higher price is charged on the inpatient

market. This calculation makes the extreme assumption that the quantity purchased does not

change when price changes. Usually, when price

rises, the quantity purchased declines. It is not

always profitable to raise price because the increase

in profits from charging more for each unit may be

less than the decline in profits that occurs when

fewer units are sold as a result of the rise in price.

2. The calculations underlying Column 4 of Table

8 account for a quantity response to a price change.

It is assumed that a 1 percent increase in price will

cause the quantity sold to fall by 0.3 percent.

Change in returns =

-33 + Ap[(621)(0.65)(0.77)(1.045)]

-Ap[(0.17)(0.946)(0.95)(0.77)(621)(0.65)

•(1.043)] + Ap[(621)(0.65)(0.23)]

- Ap(0.3)[(l-0.25)(621)(0.65)]

•[1-(0.946)(0.95)(0.77)]

-Ap(0.3)[(l-0.25-0.17)(621)(0.65)(0.946)

•(0.95X0.77)]

The first four terms are the same as in Equation

(1). The fifth term subtracts the decline in profits

because fewer units are sold on the non-Medicare

market when price rises. The final term subtracts

the decline in profits because fewer units are sold

on the Medicare market.




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