The traditional Medicare program does not have a comprehensive outpatient prescription drug benefit, but under part B (which covers physician and other outpatient services), it covers roughly 450 pharmaceutical products and biologicals. In 1999, spending for Medicare part B-covered prescription drugs totaled almost $4 billion. A small number of products accounts for the majority of Medicare spending and billing volume for part B drugs. In 1999, 35 drugs accounted for 82 percent of Medicare spending and 95 percent of the claims volume for these products. The 35 products included, among others, injectible drugs to treat cancer, inhalation therapy drugs, and oral immunosuppressive drugs (such as those used to treat organ transplant patients). The physician-billed drugs accounted for the largest share of program spending, while pharmacy supplier-billed drugs constituted the largest share of the billing volume. Three specialties—hematology oncology, medical oncology, and urology—submitted claims for 80 percent of total physician billings for part B drugs. Two inhalation therapy drugs accounted for 88 percent of the Medicare billing volume for pharmacy- supplied drugs administered in a patient’s residence. Medicare’s payment for part B-covered drugs is based on the product’s AWP, which is a price assigned by the product’s manufacturer and may be neither “average” nor “wholesale.” Instead, the AWP is often described as a “list price,” “sticker price,” or “suggested retail price.” The term AWP is not defined in law or regulation, so the manufacturer is free to set an AWP at any level, regardless of the actual price paid by purchasers. Manufacturers periodically report AWPs to publishers of drug pricing data, such as the Medical Economics Company, Inc., which publishes the Red Book, and First Data Bank, which compiles the National Drug Data File. In paying claims, Medicare carriers use published AWPs to determine Medicare’s payment amount, which is 95 percent of AWP.Thus, given the latitude manufacturers have in setting AWP, these payments may be unrelated to market prices that physicians and suppliers actually pay for the products. The actual price that providers pay for Medicare part B drugs is often not transparent. Physicians and suppliers may belong to group purchasing organizations (GPO) that pool the purchasing of multiple entities to negotiate prices with wholesalers or manufacturers. GPOs may negotiate different prices for different purchasers, such as physicians, suppliers, or hospitals. In addition, providers can purchase part B-covered drugs from general or specialty pharmaceutical wholesalers or can have direct purchase agreements with manufacturers. Certain practices involving these various entities can result in prices paid at the time of sale that do not reflect the final net cost to the purchaser. Manufacturers or wholesalers may offer purchasers rebates based on the volume of products purchased not in a single sale but over a period of time. Manufacturers may also establish “chargeback” arrangements for end purchasers, which result in wholesalers’ prices overstating what those purchasers pay. Under these arrangements, the purchaser negotiates a price with the manufacturer that is lower than the price the wholesaler charges for the product. The wholesaler provides the product to the purchaser for the lower negotiated price, and the manufacturer then pays the wholesaler the difference between the wholesale price and the negotiated price. For the part B-covered drugs accounting for the bulk of Medicare spending and claims, Medicare payments in 2001 were almost always considerably higher than wholesalers’ prices that were widely available to physicians and suppliers. This was true regardless of whether the drugs had competing products or were available from a single manufacturer. Physicians who billed Medicare for relatively small quantities of these drugs also obtained similar prices. Our study shows that there can be wide disparities between a drug’s estimated acquisition cost and Medicare’s payment for that drug. Physician-billed drugs account for the bulk of Medicare spending on part B drugs. Of those billed by physicians, drugs used to treat cancer accounted for most of Medicare’s expenditures. Specifically: Widely available discounts for 17 of the physician-billed drugs we examined averaged between 13 percent and 34 percent less than AWP. For two other physician-billed drugs, Dolasetron mesylate and Leucovorin calcium, average discounts were considerably larger—65 percent and 86 percent less than AWP. The discounts on physician-billed drugs, based on wholesaler and GPO catalogue prices, are notably lower than Medicare’s payment, which reflects a discount of 5 percent below AWP. The discounts indicate that Medicare’s payments for these drugs were at least $532 million higher than providers’ acquisition costs in 2000. Further, the discounts we report may only be the starting point for additional discounts provided to certain purchasers, as chargebacks, rebates, and other discounts may drive down the final sale price. Concerns have been expressed that small providers either could not or do not obtain such favorable prices. Therefore, we surveyed a sample of physicians who billed Medicare for low volumes of chemotherapy drugs to see if they were able to obtain similar discounts. All of the low-volume purchasers who responded to our survey reported obtaining similar or better discounts than the widely available prices we had documented. More than one-third of these physicians reported belonging to GPOs and obtained the GPOs’ substantial discounts, while others said they had contracts with manufacturers and wholesalers. As with physician-billed drugs, Medicare’s payments for pharmacy supplier-billed drugs generally far exceeded the prices available to these suppliers. For the drugs we examined, Medicare’s payments were at least $483 million more than what the suppliers paid in 2000. Further, the discounts we report were largest for products that could be obtained from more than one source. Inhalation therapy drugs administered through DME and oral immunosuppressive drugs represent most of the high- expenditure, high-volume drugs billed to Medicare by suppliers. Specifically: Two drugs, albuterol and ipratropium bromide, used with DME for respiratory conditions, account for most of the pharmacy-supplied drugs paid for by Medicare. In 2001, they were available to pharmacy suppliers at prices that averaged, respectively, 85 percent and 78 percent less than AWP. Other high-volume DME-administered drugs had prices averaging 69 percent and 72 percent less than AWP. These findings are consistent with prior studies of the prices of similar drugs. Two of the four high-volume oral immunosuppressives were available from wholesalers with average discounts of 14 percent and 77 percent. Wholesale price information on the other two was not available, but retail prices from online pharmacies were as much as 13 percent and 8 percent below AWP. Medicare payment policies for administering or delivering a drug vary, depending on who provides the drug to the patient. Physicians are compensated directly for drug administration through the physician fee schedule. Pharmacy suppliers are compensated for dispensing inhalation therapy drugs used with a nebulizer, which make up the majority of their part B drug claims. No explicit payments are made to pharmacy suppliers for dispensing other drugs, but they may receive payments for equipment and supplies associated with DME-administered drugs. Both physicians and pharmacy suppliers contend that the excess in Medicare’s payments for part B-covered drugs compensates for related service costs inadequately reimbursed or not explicitly covered at all. In prior work on the Medicare physician fee schedule, we concluded that the agency’s basic method of computing practice expense payments to physicians was sound. The implementation of this fee schedule, however, has been controversial. The Congress required that payments be budget neutral relative to prior spending. Medicare’s physician payments were, in the aggregate, seemingly adequate, as most physicians were participating in Medicare and accepting the program’s fees as payment in full. Because of the budget neutrality requirement, if one specialty’s fees increased on average, some others would have to decline. Such redistributions have occurred and some are significant. Oncologists, who represent the majority of physicians billing for drugs, argue that Medicare’s payments for administering chemotherapy are inappropriately low and that the excess Medicare drug payments are needed to offset their losses. Yet oncology is one of the specialties to gain under the resource-based physician fee schedule. In our separate study on physicians’ practice expenses under Medicare’s fee schedule, we will show that payments to oncologists were 8 percent higher than they would have been if the prior charge-based payment method had been maintained; the study will also show that oncologists’ payments relative to their estimated practice expenses, which include chemotherapy administration, were close to the average for all specialties. While oncologists do not appear disadvantaged overall under the fee schedule, adjustments HCFA made to the basic method of computing payments reduced fees for some oncologists’ services. In those adjustments, HCFA modified the basic method in computing payments for services delivered without direct physician involvement, like much of chemotherapy administration. The modifications were intended to correct for perceived low payments for these services. While they increased payments for some of these services, they lowered them for many others. Moreover, they increased payments on average for services involving physicians. Oncology payments were particularly affected, as services without physician involvement constitute about one-third of oncologists’ Medicare-billed services, compared to about 5 percent of all physician- billed services. Because of the modifications to the basic method, oncology practice expense payments for nonphysician chemotherapy administration were on average 15 percent lower, while payments for physician-administered services were 1 percent higher, than if HCFA had used the basic method. Across all services, the modifications resulted in oncology practice expense payments that were 6 percent lower. Using the basic method for all services would eliminate these reductions and add about $31 million to oncology payments. Our study will recommend that CMS revert to the use of the basic methodology to determine practice expense payments for all services.