Addressing the Rising Cost of

Prescription Drugs

January, 1999

I. Addressing the Rising Cost of Prescription Drugs

For the past three years, the annual increase in the total cost of prescription drugs purchased by Americans has averaged 16 percentBabout five times the general rate of inflation. The cumulative pressure of these increases began to be felt sharply in 1998, as insurance companies began to raise co-payments for prescription drugs drastically. Alarm spread, especially among senior citizens, who use prescription drugs more often than younger people and who typically have less insurance coverage. The debate of the pricing of prescription drugs and insurance policies moved to the center of the national stage, especially as the federal government began to discuss the reorganization of the Medicare and Medicaid programs that provide health care for the nation=s elderly and its poorest citizens.

The surge in spending for prescription drugs has been most challenging for those over 65. They make up 14 percent of the population but consume 30 percent of the prescriptions written in the United States. According to a study conducted last summer by the House Government Reform and Oversight Committee the average senior citizen spends $350 a year out of pocket for prescriptions, compared with $69 for the average person under 65. A study released in January by the Commonwealth Fund estimated that 11 percent of current Medicare recipients spend more than $100 a month of their own money on prescription drugs.

Retired senior citizens are the most vulnerable to escalating cost of prescription medicine: they need more prescription drugs than others, often to control one or more chronic medical conditions, and they are typically on fixed incomes. In addition, many now face the challenges of coping with rapidly changing insurance coverages. This has all been reflected over the past year in a surge of media of the struggles of senior citizensBsome of whom face drug bills of hundreds or even thousands of dollars a month.

The current developing crisis has no simple source. It grows out of the interaction of several different institutions and social policies that has been developing for decades. Before exploring in some detail the policies of pharmaceutical manufacturers and insurance companies, it is wise to look at several broad trends that have shaped the current problem.

1) The role of the federal government. Federal action in the mid-1960s created the Medicare and Medicaid health insurance programs. No other factor has played such a large role in improving the medical care of Americans, especially for the elderly and others who could not afford traditional fee-for-service medicine or had no insurance. Faced by dramatically escalating costs and increases in the number of the elderly, for the past 20 years the federal government has been searching for ways to limit the rapid escalation of health care spending. The first step, in the 1980s, was to develop standard national patterns for diagnosing and treating health problems, to establish fixed payment schedules, and to discourage long hospitalizations. By the 1990s, federal policy makers were seeking ways to introduce managed health care and seeking to cap health care spending.

2) Changes in medical technology and practice: When Medicare and Medicaid were designed in the 1960s, the problems of paying for doctors, hospital treatment and nursing home care dominated planning. Prescription drugs played a relatively small role in the management of most illness, even chronic ones. But over the succeeding decades, major scientific advances, new drug therapies, and new economic polices that emphasize outpatient treatment took hold. About 10 percent of total health care spending is now devoted to prescription drugsBand other advanced industrial nations spend an even larger percentage (Japan is currently spending 20 percent). But Medicare and Medicaid have never been restructured to address this emerging and significant change. Medicare, in particular, does not cover the cost of prescription drugs for outpatient use.

3) The surging growth of the pharmaceutical industry: The pharmaceutical industry has emerged as a high profit and global industry that brings wave after wave of new, useful and high cost drugs to the marketplace. Profits are very high by the standards of other manufacturing industriesBthe 10 leading global drug makers made a combined total of $20 billion in 1997, according to Forbes Magazine. Their average operating profit margin was 28.7 percentBabout three times that of leading manufacturers in other industries. Drug makers point out, however, that they take enormous investment risks to produce their product-- it takes 12 to 15 years and up to $500 million to bring a new drug through research, development and testing before it can be brought to market in the United States.

4) Instability in the insurance market: Insurance that covers prescription drugs is still a relatively new thing. As recently as the early 1980s, less than 20 percent of the American population belonged to third-party insurance programs that covered any prescription medications at all. Rapid growth brought that figure to 65 percent in the late 1990s. As insurance companies have taken the key position in the management of health care, they have hadBat bestBmixed success in making profits by providing coverage for prescription drugs. During the 1990s, the federal government has pushed private insurance companies to offer managed care alternatives to the standard Medicare fee-for-service programs. And in many of these programs, coverage for prescriptions was a key enticement for senior citizens to sign up. But during 1997 and 1998, many companies found that rising drug prices defeated their efforts to bring cost efficiencies to managed care for the elderly. Beginning in 1997, many managed care companies announced the termination of their Medicare HMO plans, creating a ripple of panic. At the least, many senior citizens are now faced with the prospect of making complex decisions about which manage care programs to join and the likelihood that they will have to shift from plan to plan as the years pass.

II. New Drugs, New Profits

The most important factor in the current surge in prescription drug spending is the activity of the pharmaceutical companies. As drug company officials see it, the current situation is the result of a) more people taking more prescription drugs, and b) the introduction of a new generation of expensive new drugs. And, in fact, drug companies are not, by and large, significantly increasing the costs of existing drugs.

Drug companies argue that their high profit margins are necessary to cope successfully with the particular circumstances of their industry. Pharmaceutical companies, they say, assume all of the risks of the very expensive and lengthy process of drug research and testing. In addition, when a new drug is brought to market, U.S. patent law protects the manufacturer for only 20 years. Then competitors are free to bring Aknock-off@ or Ageneric@ versions of the drug to market that will lower the price of a drug dramatically. Drug companies, have, they say, only a fixed period to recoup their investment and reap profits on a new drug.

And, while the research and testing phases of drug development are risky and highly regulated, the pricing of newly approved prescription drugs is not regulated at all in the United States. This reflects the long-standing American preference for free markets, but it means that Americans usually pay much high prices for prescription drugs than residents of other nations. Recent comparative studies have shown that Canadians typically pay about 60 percent of American price levels and that many Europeans and Latin Americans pay one third to one half of American prices for identical drugs. At least in Europe, Canada, and Japan, the price differential is largely the result of government policies that regulate drug prices stringently and of the existence of national health care systems.

Because of the strict regulatory climate elsewhere, most of the world=s news drugs are developed in the United States, which is also the single largest market for pharmaceuticals. Drug companies argue that price regulation by the United States would discourage new drug research, result in job losses, and cost the United States its world leadership in a key high technology industry. And, at this point, there=s little visible support for any effort to regulate drug prices here. Instead, American efforts appear to be focused on capping government spending for pharmaceuticals. Drug companies will probably, therefore, continue to be able to set their own prices for drugs.

Aggressive marketing as a new factor: New drugs play an important role in driving spending for medical care upward, but the pharmaceutical industry=s increasing skill in marketing also shapes the current situation. Two recent developments are illuminating: the industry=s surprising success at limiting the impact of Ageneric@ drugs, and its large-scale efforts in the consumer marketplace to influence the choices of doctors and patients.

At the beginning of the 1980s, many experts seeking cost efficiencies in health care predicted that the use of Ageneric@ drugs, which are chemically identical to Aname-brand@ drugs, would become a major source of savings. Generic drugs, which are usually based on name brand drugs which are no longer protected by a patent, are used on a wide-scale (and encouraged by insurance programs). But their impact has been much smaller than many experts expected. In 1998, generics made up half of the total prescriptions, but cost only 10 percent of the total spent on drugs.

During the 1980s, drug companies mobilized to face competition from generic drugs (which are often produced by companies that only manufacture generics) and succeeded in creating formidable brand loyalties to their Aname brand@ drugs. They did so mostly by increasing advertizing and expanding the practice of giving doctors free test samples of name brand drugs to pass on to patients. Companies producing generic drugs rarely employ sales staff to visit physicians. As a result, both doctors and patients remain very loyal to the name brands.

In the last few years, the pharmaceutical industry also has expanded its marketing activities dramatically in order to defeat pressures to control costs. They seek, especially, to create an appetite for the new and relatively high-priced drug therapies they are bringing to market. Indeed, in their eagerness to recoup large up-front investments, the industry now aims straight at consumers. Elaborate television and magazine advertising campaigns are now common, with pitches that tell consumers to ask their doctors to prescribe specific name brand drugs that allegedly produce major breakthroughs the treatment of allergies, impotence, indigestion, hair loss, and so on.

Some companies have also begun to use high technology marketing practices that are even more aggressive. Some for-profit Aprescription management companies@ now search computerized patient health records to find patients who could be candidates for particular new drugs produced by their owners or clients. The Hartford Courant carried a report last July about a Middletown physician who received calls from PCS Health Systems suggesting by name some of her osteoporosis patients who it felt would benefit from prescriptions of the drug Evista. Dr. Deborah Mueller told the Courant that she discovered that both PCS Health Systems and Evista were owned by the giant pharmaceutical concern Eli Lilly and Company. She said the practice of companies screening medical records data bases for potential customers is both intrusive and Aa thinly veiled promotion for their own drug.@

III. The Insurance Mess:

Most Americans have medical insurance the covers at least a substantial portion of their prescription drug costs. As a result most were shielded from the full impact of the rapid escalation of drug prices. In 1998, however, insurance companies began to devise new ways of passing increasing costs along to their customers. The resulting increases in the cost of insurance coverage, and especially in the Aco-payments@ customers make when they purchase drugs at the pharmacy, have been a substantial blow, particularly to customers on fixed incomes.

By and large, prescription drug benefits developed as part of the managed care revolution in health care insurance. In 1969, only 12 percent of the population was covered by policies that offset the cost of prescription drugs. By in 1990, 40 percent of the population had that coverage, and by 1997, 65 percent of the American population was covered by policies that provided prescription drug benefits. This number includes most retirees, who typically remain covered to some degree by insurance carried by their former employers.

Insurance companies typically followed a range of strategies intended to lower the cost subsidizing prescription drug purchases for their clients. They encouraged the prescription of generic drugs, often by establishing a two-tier structure of client Aco-payments@ for drug purchases. Those who selected generic drug options paid a small co-payment for each prescription, often $2 during the early and middle 1990s. When doctors or patients insisted on name-brand drugs, the co-payment was typically $5 or more per prescription. Following general managed care practice, insurance companies often used their buying power to negotiate special bulk purchase rates for name brand drugs. In addition, manage care companies often encouraged their customers, especially those who needed prescriptions to treat chronic conditions, to purchase their prescription drugs in bulk from mail order pharmacies.

For most of this decade, working people rarely encountered limits on their prescription purchases, either because they rarely used prescription drugs or because their employers purchased insurance plans to high coverages for drugs. That situation began to change significantly in the mid-1990s as the introduction of new and expensive drugs began to cause strains in managed care programs. Many managed care firms began to introduce lists of approved drugs, usually called formularies and to press doctors and customers to use only the drugs listed on a particular carrier=s formulary.

The formularies give insurance companies the ability to steer clients toward the use of generic drugs and the particular name brand drugs for which they have bulk purchase agreements. (These bulk purchase agreements typically allow companies to purchase drugs at up to 50 percent of the retail price.) In 1996 and 1997, the use of drug formularies spread, even though there was considerable resistence to their use by doctors and consumers.

By the mid-1990s, generic drugs were reasonably widely accepted. In addition, patients encountered few real difficulties when generic drugs were prescribed. This is because generic drugs are chemically identical to the Aname brand@ drug they are copied from. Customer and physician resistence has centered on the so-called Atherapeutic substitution@ of one prescription drug for another.

The practice of therapeutic substitution grows out of proliferation of prescription drugs that have been developed over the past several decades. More than one hundred different drugs, for example, have been approved by the FDA for the treatment of hypertension. Some are new, some are old. Some are expensive, some are cheap. Since they have different chemical compositions, they have varying side-effects. Therapeutic substitution occurs when an insurance company suggests or insists that a drug on its preferred-use list be substituted for an expensive drug prescribed by a doctor. Problems arise because people are different and have different reactions to drugs. Many patients have adverse reactions to some families of drugs, even though these drugs are indeed approved for use to treat their particular problems. Most therapeutic substitutions don=t cause problems, but in 1997 the FDA did call for reports of adverse effects following therapeutic switching. Analysis of the results showed that while serious complications are rare, there are often problems, not only in terms of patient conditions, but also in terms of the stress, time and energy needed to recover for a therapeutic substitution that disagreed with a patient.

Those therapeutic switches most likely to cause problems, according to a report by the New York City Public Advocate=s office, involve medications for high cholesterol, hypertension and depression. In addition, it is the elderly, who are most likely to be taking several prescribed drugs at a time, who are the most likely to be troubled by problems caused the formulary-driven therapeutic substitutions.

Formularies as Barriers: It is also clear that most managed care companies have used formularies to blunt the impact of expensive new drugs. As these new drugs have come onto the market, managed care companies have attempted either to strike bulk-purchase agreements or to seek to avoid covering them altogether. From the managed care companies point of view, the problem began to grew more severe in 1996 and 1997 with the introduction of expensive, highly-promoted drugs such as Viagra and Claritin, which is prescribed for allergy sufferers. By 1998, rising spending for drugs was causing deep dents in insurance company profit margins. By the fall of 1998, many companies were announcing sharp increases in overall costs of their health insurance policies, and often created a new three-tiered structure for prescription medicine co-payments.

In many areas of the country, the new co-payment policies have retained very low customer co-payments for generic drugs, often in the $2 range. Co-payments for name brand prescriptions covered by bulk purchase agreements have risen into the $8 to $10 range. A new category has been created for other, Aunapproved@ prescription drugs demanded by customers and physicians. In this third category, co-payments have risen into the range of $20 to $25 each time a prescription is filled. For many customers, especially among the elderly with multiple prescriptions, these changes mean that the out-of-pocket costs for their prescriptions have risen three- to fivefold since the beginning of 1998. Over the course of a year, this can total hundreds, or even thousands of dollars, in new costs for women and men who typically live on fixed incomes.

This is where the drug price crisis shows itself. It is a crisis delivered by insurance companies, but since they are largely passing increased costs along to the consumer, it is not a crisis that they have caused. The situation is, of course, even worse for the 35 percent of senior citizens who have no prescription benefits at all and who must pay full retail prices for all prescription purchases.

The Medicare HMO Upheaval: Since the early 1990s, a small but significant portion of the elderly covered by Medicare have elected to move their medical insurance coverage from the traditional Medicare fee-for-service program into new managed care plans called Medicare HMOs, which are operated by private and non-profit health insurance providers. The federal government has strongly encouraged both insurance companies and the elderly to move into managed care insurance programs that designed to function under the Medicare umbrella. Ten percent of the Medicare population is now enrolled in Medicare HMOs.

This policy began in the early 1990s as part of a conscious effort to bring managed care, which holds out the promise of more efficient health care at reduced cost to the largest single segment of the American population still covered by traditional fee-for-service medical insurance, those covered by Medicare. The move toward managed care was regarded as a key component in the effort to keep Medicare solvent in an era of rise health care costs and in the prospect of a burgeoning elderly population as the Baby Boom generation moved toward retirement.

Since Medicare has never provided a prescription drug benefit and since Medicare has failed to keep pace with or cover the entire cost of treatment for the elderly, a large percentage of the nation=s senior citizens purchase supplementary medical insurance, typically called AMedigap@ insurance. And despite the fact that these Medigap policies can cost several hundred dollars a month, most provide few or no prescription benefits either. Federal policy makers and executives of managed care companies reasoned that AMedicare HMO@ plans that offered customers drug benefits would be very attractive to senior citizens. During the mid-1990s, many managed care organizations responded to federal encouragement by designing Medicare HMO plans priced to fall within the scope of what Medicare was willing to pay and which offered subscribers prescription drug, vision, and sometimes dental benefits. The prescription drug benefits offered typically included low co-payments and a total of $600 to $1,200 a year in total coverage. Drug benefits at these levels did not solve the problems of those struggling to pay for very large drug bills, but they did meet the needs of the majority of senior citizens who enjoy relatively good health.

New Medicare HMO plans were aggressively advertised in many parts of the nation in 1996 and 1997. And there was a perceptible shift toward enrollment in these plans, a step often encouraged by the government, consumer advocates, former employers, and even associations of the elderly. In particular, the Medicare HMOs were seen as a way of avoiding costly Medigap policies while reaping new drug benefits.

Unanticipated failures: But in many parts of the nation, the drive toward enrolling senior citizens in privately managed health insurance programs began to collapse in 1998. Last summer and in the early fall, many insurers began to announce plans to cut drug benefits and even to pull out of the Medicare HMO market in particular location because of low profits or even losses. In general, managed care firms reluctantly agreed that they had underestimated the cost of providing health insurance to an elderly population, underbid to beat rival firms, and failed to anticipate the continuing surge of drug prices. The Medicare HMO market was also shocked when the federal government announced that it would be passing on only a 2 percent annual increase in Medicare funding to manage care operations, and it became clear that the Congress meant business when it discussed ways of capping federal spending on health care.

As a result of this turmoil, many senior citizens fell pushed toward manage care plans that provide shifting or shrinking benefits and which lack the iron-clad guarantees of traditional fee-for-service Medicare. Those making insurance decisions are now faced by the likelihood that they will have to make very complicated decisions about health care coverage, and may have to choose new health insurance providers at frequent intervals, a process that often means selecting new doctors and struggling to master the intricacies of a new bureaucracy.

IV. New Interventions, New Solutions from Washington?

Because of the turmoil caused by surges in prescription prices, the vulnerability of an increasing number of senior citizens who have no prescription benefits, fears about the long term fiscal stability of Medicare, and the new possibilities created by the federal budget surplus, 1999 looks like a year of decision for federal health care policy.

There are two focal points for this debate: the deliberations of the federal Medicare Reform Commission, which will present its report to Congress on March 1, and President Clinton=s recent proposal to use funds from the new federal budget surplus to refinance Medicare and include prescription drug coverage in Medicare for the first time.

A) The Medicare Reform Commission: The prescription drug cost crisis has played a key role in the deliberations of this 17-member national commission assigned to draft a plan to put Medicare on a financial footing strong enough to survive the movement of the Baby Boom generation through retirement. Most observers believe this can be achieved only if the federal government scales back its financial commitment to cover all of the health care needs of all senior citizens.

The reform commission, chaired by Sen. John Breaux of Louisiana appears likely to propose radical change in Medicare financing designed to encourage growing more senior citizens to join HMOs and other managed care plans. Under the proposal apparently now on the table, the federal government would offer a fixed amount of money to each person covered by Medicare. He or she would then buy insurance covering a comprehensive package of health benefits, including doctors=s services, hospital care, and possibly prescription drugs. The age of eligibility would be raised from 65 to 67.

Those covered by Medicare could choose between the traditional-fee-service program, which allows them to choose any doctor or hospital, and a selection of HMOs and other managed care plans. Because a recipient=s costs would be higher in the traditional fee-for-service and more elaborate managed-care plans, it is expected that many people would enroll in cheaper managed care plans with relatively limited benefits.

The key component of the plan designed to limit federal health care spending is to create a system in which the sum paid by the government toward policy premiums would be at 88 percent of the national average cost of a health care plan. Recipients would then be obliged to pay up the remaining 12 percent pf the health insurance premium, as well as co-payments and deductibles.

The proposal also suggests introducing a means test, that would ask the most affluent retirees to pay more than others. Under the Breaux proposal, elderly couples with an income of $50,000 and individuals with an income of $40,000 would pay 25 percent of their insurance premiumsBmore than twice as much as less affluent beneficiaries. In contrast, those living below established poverty levels would pay nothing toward their policy premiums.

Under the plan, all approved managed care plans would cover the same categories of benefits as the traditional fee-for-service Medicare plan, but the specifics, such as guidelines on how long a patient=s hospital care is covered, would be determined by the individual plan, subject to the approval of a new national review board.

Some reform board members predict that the changes proposed could result in a 30 percent increase in premium costs to beneficiaries without any guarantees of new benefits. Liberal critics are concerned that the main effect of the reform will be to shift more affluent retirees into private insurance plans, leaving perhaps 12 million senior citizens with significant health problems with health insurance that costs them more and serves them less. But many on the panel are willing to consider the proposal because the provision of drug benefits might justify the cost increases for most senior citizens.

As of early February, there were important partisan debates within the commission about how prescription benefits would be offered. Many Republicans and representatives of the pharmaceutical industry are insisting that drug benefits be offered only in the managed care insurance options, which would then provide a substantial incentive for most seniors to choose privately managed health care insurance. Over the long term, Republicans argue, health care costs can only be controlled by improving efficiencies through managed care. Government solutions are fated to be wasteful and ineffective.

Democrats, on the other hand, want prescription benefits to be added to the traditional fee-for-service option as well as to managed care options. Although likely to be more costly in the long run, this option will guarantee, Democrats say, that the elderly and disabled can compare health care options based on cost and quality, rather than choosing a plan based solely on the profits it offers.

The Clinton Proposal: The politics and potential economics of Medicare reform shifted dramatically in January during President Clinton=s State of the Union Address. He argued then that some of the new and substantial federal budget surplus could be used to support expansions in Medicare, particular to provide prescription drug benefits. This marked the first time in many years that a federal official had suggested any possibility of an expansion of Medicare. Clinton proposed that one sixth of the projected federal surplus over the next $15 yearsBand estimated $650 to $700 billionBbe used to replenish the federal Medicare trust fund and to provide drug benefits to Medicare beneficiaries.

Interested parties will be mobilizing intensely over the next few weeks. This is the moment when organized interest groupsBcertainly including representative of the elderly and the beneficiaries of MedicareBwill have maximum opportunity to reshape federal policy.

One clear area of controversy will be whether the federal government uses its economic clout to force pharmaceutical companies to cut their prices for beneficiaries of Medicare. The federal government, like managed care insurance firms, already uses its economic and demographic clout to negotiate special discounts to its employees, retirees, and participants in the Veterans Administration health care system. These discounts often rise to 50 percent of the retail price.

Drug companies are extremely concerned that as part of Medicare reform the federal government would develop its own national formulary for the Medicare program. The 38 million Americans now covered by Medicare would command immense power in the marketplace and pharmaceutical makers are afraid that government formularies could create a form or indirect price controls on their products. ASeniors account for one-third of the market,@ Alan Holmer, president of the Pharmaceutical Research and Manufacturers Association told the New York Times on January 29. AAny practices that would affect such a large proportion of patients becomes trend setters for all health plans, for better or worse.@

In the mean time, Congressional Democrats are mobilizing for a major debate over coverage of prescription drugs. Rep. Peter Stark of California and Sen. Edward Kennedy of Massachusetts are drafting bills to authorize Medicare coverage of prescription drugs. Reps. Tom Allen of Maine and Jim Turner of Texas have reintroduced legislation that would mandate the creation of federal formularies that would provide Medicare beneficiaries with prescription drugs at negotiated prices.

Republicans, on the other hand, are mobilizing to argue that the power of the federal government should not be extended and that private, managed health care provides the best quality care and the best hope for containing federal spending on health care.

It=s a plastic moment and it=s unlikely that the status quo will continue.