Alternative Strategies for Medicare Payment of Outpatient Prescription Drugs"Part B and Beyond

March 1, 2005
Patricia M. Danzon, PhD

Gail R. Wilensky, PhD

Kathleen E. Means, BS

Volume 11, Issue 3

Reimbursement options for pharmaceuticals reimbursed underMedicare Part B (physician-dispensed drugs) are changing and thenew comprehensive Part D Medicare outpatient drug benefit bringsfurther changes. The Medicare Prescription Drug, Improvementand Modernization Act of 2003 (MMA) replaces traditional policy,of reimbursing Part B drugs at 95% of average wholesale price(AWP, a list price), with a percentage markup over the manufacturer'saverage selling price; in 2005 an indirect competitive procurementoption will be introduced. In our view, althoughAWP-based reimbursement has been fraught with problems in thepast, these could be fixed by constraining growth in AWP and periodicallyadjusting the discount off AWP. With these revisions, anAWP-based rule would preserve incentives for competitive discountingand deliver savings to Medicare. By contrast, basingMedicare reimbursement on a manufacturer's average selling priceundermines incentives for discounting and, like any cost-basedreimbursement rule, may result in higher prices to both public andprivate purchasers. Indirect competitive procurement for drugsalone, using specialty pharmacies, pharmacy benefit managers, orprescription drug plans, is unlikely to constrain costs to acceptablelevels unless contractors retain flexibility to use standard benefitmanagement tools. Folding Part B and Part D into comprehensivecontracting with health plans for full health services is likely tooffer the most efficient approach to managing the drug benefit.

(Am J Manag Care. 2005;11:173-180)

The Medicare Prescription Drug, Improvementand Modernization Act of 2003 (MMA) radicallychanged coverage and reimbursement for outpatientpharmaceuticals. The MMA established MedicarePart D, which provides comprehensive outpatient prescriptiondrug coverage for seniors, starting in 2006.This benefit is to be administered by stand-alone privateprescription drug plans (PDPs), whose role is to negotiatedrug discounts and process claims on behalf of thegovernment. More immediately, MMA changed the rulesfor reimbursement of physician-dispensed drugs, whichare already covered under Medicare Part B. Specifically,starting in January 1, 2004, reimbursement for mostPart B drugs was reduced from 95% of their currentaverage wholesale price (AWP) to 85% of their AWP onApril 1, 2003. Beginning in January 1, 2005, reimbursementfor single-source (mostly on-patent originator)drugs is 106% of their average selling price (ASP) orwholesale acquisition cost (WAC), whichever is lower.Reimbursement could be lower if the widely availablemarket price is at least 5% less than the ASP. For multiple-source drugs (generics and off-patent brands),reimbursement is based on the ASP subject to a maximumallowable charge (MAC) limit. (The MAC is basedon the ASP of a low-priced product in the molecule.)The ASP is intended to represent the volume-weighted,average manufacturer selling price net of rebates anddiscounts, to all purchasers excluding Medicaid andfederal purchasers.

Beginning in 2006, Centers for Medicare & MedicaidServices (CMS) will begin a competitive acquisition programas an option for dispensing physicians. The organizationwill select, by competitive bid, at least 2contractors in each area to be responsible for negotiatingdrug prices with manufacturers and delivering drugsto physicians. Physicians may opt to continue their owndrug purchasing, with the ASP/WAC reimbursement inplace for 2005, or they may obtain Part B drugs from 1of the contractors in their area. Under this option,physicians will no longer acquire Part B drugs frommanufacturers or seek reimbursement from CMS; thesefunctions will be assumed by contractors, along withany associated profit or loss. Many details of the competitiveacquisition program remain to be determined,including defining the geographic areas and setting standardsfor quality, access, financial stability, and solvency.Under the legislation, CMS is to make recommendationsto Congress by January 2005 on whether Part B drugsshould become part of the Part D benefit, but newlegislation would be required in order for that changeto occur.

The efficient design of Medicare payment policies fordrugs is a critical issue, given the fiscal pressure impliedby this benefit and its potential effect on private sectorpayers, the pharmaceutical industry, and ultimatelyconsumers. The elderly, who currently represent about12% of the US population, consume about 40% of pharmaceuticalssold in the United States; this share isexpected to increase as the US population ages. Althoughmore than 78% of seniors already have some drug coverage,1 the Medicare drug benefit expands and consolidatesthis coverage, making Medicare the dominantpayer for pharmaceuticals in the United States. ThusMedicare's reimbursement strategies will influence pharmaceuticalprices and profitability, and ultimately incentivesfor research and development (R&D) and theavailability of new drugs for consumers worldwide.

Here we review Medicare's payment options fordrugs, comparing the effects of alternative administeredpricing rules—specifically, rules based on list versustransactions price—and alternative competitive strategies,in the context of the economic realities of pharmaceuticalpricing. We evaluated the effects of thesevarious policies for Part B drugs, because reimbursementrules are already defined and Medicare is alreadythe dominant payer. We draw conclusions from the PartB experience for the larger Part D benefit and for stateMedicaid and private payers.


Several recent reviews of Medicare's Part B drug policyhave been excellent.2,3 Here we provide a brief historicalperspective, as background to the discussion offuture reimbursement options.

Medicare Part B traditionally covers outpatient drugsthat are related to a physician's service or a coveredmedical device and some immunosuppressive drugs.About 75% of current reimbursement is paid to physiciansfor drugs that they acquire, primarily chemotherapy,other cancer treatments, and other infusion drugs.In 2002, Medicare spent about $8.4 billion on thesedrugs, up from $6.5 billion in 2001 and $4 billion in1999 (Bill London, personal communication, February2, 2005). The almost 3-fold increase between 1998 and2002 implies an average annual growth of 27%, farexceeding the annual growth rate of private-sector outpatientdrug spending.

Prior to 2004, Medicare's payment for Part B drugswas set at the AWP minus 5%. The AWP as a concept forreimbursement originated in the 1960s in response to awide variety of "cost"prices used by wholesalers,direct-selling manufacturers, specialty wholesalers, andpharmacies. Led by Medi-Cal (California's Medicaidprogram), AWP was adopted as a "standard cost definitionthat would reflect what wholesalers normallycharged for the drug."Starting in 1969, Medi-Cal paidpharmacies AWP plus a flat dispensing fee to cover thepharmacist's professional service. The initial problem ofnot having a listing of such prices was resolved whenfirst the Red Book and then the Blue Book starting publishingAWPs as reported by drug wholesalers.4

In 1991, the Health Care Financing Administration(HCFA, the predecessor agency to CMS) announced thatoutpatient drugs would be reimbursed at the lower ofAWP or the estimated acquisition cost, to be determinedby surveys of actual prices paid by physicians and otherproviders who dispensed these drugs. However, HCFAsubsequently decided that this strategy was unworkablebecause of the large number of providers and the widevariations in their use of drugs and the prices paid. Inthe 1997 Balanced Budget Act, reference to estimatedacquisition cost was deleted and AWP minus 5% becamethe sole basis for reimbursement.

The AWP has become a list price that is set by thedrug's manufacturer and published by pricing servicessuch as the Red Book. With AWP not defined in eitherstatute or regulation and no requirements or conventionsthat AWP reflect actual market prices, theGeneral Accounting Office (GAO) reflected consensusopinion when it concluded that AWP "may be neitheraverage nor what wholesalers charge."5,6 Some eventranslate AWP as "ain't what's paid."Studies by theGAO and the Department of Health and HumanServices Office of the Inspector General have consistentlyconcluded that this standard results in paymentby Medicare that significantly exceeds providers'acquisitioncost for most drugs and biologics, and excessiveco-payments by beneficiaries, who pay 20% of thecharge.7 The physicians who administer Part B-covereddrugs and are the chief beneficiaries of the spreadbetween AWP minus 5% and their actual acquisitioncosts argue that overpayment is needed to compensatefor inadequate Medicare payments for drug administration.6 Whatever its empirical validity, this claim thatoverpayment for drugs makes up for inadequate physicianfees kept Congress from reducing Part B drug paymentsuntil the MMA, which raised payments forselected professional oncology services.

Before dismissing an AWP-based approach, it is worthnoting that many private sector payers, who are presumablymotivated to minimize costs and who lack thestatutory constraints faced by Medicare, also traditionallybase their drug reimbursement to pharmacies on discountedAWP. The critical difference is that privatepayers apply a larger percentage discount and revise thepercentage periodically, to capture most of the spreadbetween AWP and the pharmacy's actual cost of acquiringdrugs. Thus, the real questions are (1) could an AWP-basedapproach for Medicare be revised to eliminate itsprior problems; (2) how does a revised AWP approachcompare to using ASP or some other transactions priceas the basis for reimbursement; and (3) will competitivebidding strategies provide a superior alternative?


Sound payment policy for any medical serviceshould provide reasonable cost control while creatingincentives for efficient utilization. In the case of pharmaceuticals,sound payment policy must also considereffects on incentives for R&D. Given the cost structureof research-based pharmaceuticals, with high fixedcosts of R&D and low marginal costs, the concern is thata large payer such as Medicare might use its monopsony(single buyer) power to force prices down to marginalcost, which would erode incentives for R&D. Becausepharmaceutical R&D takes 8 to 15 years, the effect ofinadequate prices on the flow of new drugs would not beevident until many years later, in contrast to inadequateprices for other medical services in which providers'withdrawal of services acts as a prompt corrective toinadequate prices.

So far, both Medicare and Medicaid have adoptedreimbursement practices similar to those used by privatepayers, but with important differences. Both publicand private payers overwhelmingly pay for drugs indirectly,reimbursing the dispensing pharmacist or physicianfor their cost of acquiring the drugs plus adispensing fee, rather than paying manufacturersdirectly. A fundamental challenge in designing thesereimbursement rules is that payers do not observe theacquisition costs paid by dispensing pharmacists andphysicians, and these acquisition costs may vary,reflecting manufacturer discounts geared to volume,prompt payment, incentives to increase market share,and bundling. Any spread between the payer's reimbursementfor the drug and its acquisition cost accruesas income to the dispensing pharmacy or physician,regardless of whether the payer's benchmark for reimbursementis AWP or some proxy of acquisition cost.Because each provider's actual acquisition cost is unobservable,the payer can at best hope to roughly approximateaverage acquisition cost, while having a neutraleffect on prescribing and dispensing choices (unless thepayer specifically wishes to influence usage, such asencouraging generic substitution).

The fact that providers capture some spread betweenreimbursement and acquisition cost of drugs is oftenviewed as inappropriate. In fact, such margins betweenreimbursement and cost may occur for all medical services.Although the payer may appear to pay too much inthe short run, in the longer run the potential forproviders to capture such margins reinforces theirincentives to try to reduce their costs. Indeed, makingproviders cost-conscious, by giving them both upsideand downside risk for costs, was a key objective in theswitch from cost-based reimbursement to prospectivepayment for hospitals and physicians. In the case ofdrugs, permitting dispensers to capture some spreadbetween reimbursement and acquisition cost createsincentives for them to be price-sensitive, which in turnleads drug manufacturers to compete by cutting prices.

Such competition can yield savings to payers, providedthat manufacturers cannot simply increase thespread by raising the AWP and that payers reduce theirpayment to reflect lower acquisition prices. Many privatepayers take advantage of this system, reimbursingretail pharmacies based on AWP minus a percentage— now roughly 15% to 18%—that has increased over timeas the spread has increased. Many Medicaid programsuse a similar approach as at least 1 option for pharmacyreimbursement. Similarly, the key drivers of genericprice competition in the United States are that pharmaciescan substitute between approved generics and cancapture the spread between the payer's reimbursement,usually a MAC and their acquisition cost. By makingpharmacists price-sensitive, this system creates incentivesfor generic manufacturers to compete on the pricesthat they offer pharmacies, to increase their share of thepharmacy's business. Thus although the reimbursementspread may appear inappropriate, it serves the importantpotential function of encouraging price competitionby manufacturers, which can yield savings to payers ifreimbursement is adjusted down in line with costs.

An alternative approach is for the payer to define thepermissible manufacturer price for the drug, adding amarkup to cover wholesalers and dispensing costs.Countries that regulate drug prices generally apply thisapproach to regulating the manufacturer's price atlaunch. Price regulation uses 1 of 3 benchmarks: (1) theprice of competitor products in the same class as thenew drug (internal referencing); (2) the price of thesame drug in other countries (external referencing); or(3) some estimate of manufacturer costs. None of theseapproaches meets the criteria for sound payment policyto manufacturers. Internal referencing raises issues ofappropriate markups for innovation or superior safetyor efficacy, and for on-patent versus generic status;external referencing simply imports foreign price controlsand undermines appropriate cross-national pricedifferentials; and cost-based reimbursement for pharmaceuticalsis doomed by problems of measuring andallocating joint cost.8,9

The hope of both the administered pricing rules andcompetitive contracting options proposed for Medicareis that these can constrain prices to reasonable levelswhile avoiding the opposing risks of forcing prices downto marginal cost or, alternatively, paying inappropriatelyhigh prices.


We focus here on options for paying for Part B drugsas outlined in MMA; options for Part D would be similar.These options fall into 2 broad categories (Table). First,Medicare could define administered pricing rules, basedon either a list price or an estimated transactions price,with discounts or markups. Any administered pricingrule could use internal reference pricing, wherebyMedicare sets a single reimbursement level for all drugsin designated groups. Second, Medicare could use competitivebidding strategies, either contracting with manufacturersdirectly or indirectly, through pharmacybenefit managers (PBMs), PDPs, or health plans.Indirect contracting could encompass a range of possibleservices, from Part B drugs only to comprehensivehealth benefits.

List Price With a Discount or Markup

A discounted list price approach, such as AWP minus5% or 15%, has the obvious advantage that list prices areeasily obtained from pricing services. A less obvious butkey economic advantage is that this approach encouragesprice competition below the prevailing reimbursementlevel, as manufacturers seek to increase thespread to providers, as discussed above.

Two modifications of Medicare's traditional AWP-basedstrategy are necessary to make it attractive. First,Medicare should have the flexibilityto adjust the discountover time to keep reimbursementroughly in line withacquisition costs, as determinedby audit of markettransactions, and enableMedicare to share in the savingsfrom price competition.Second, the rate of increase inAWP should be constrained,for example, to the rate ofincrease in the consumer priceindex or producer price indexfrom a predetermined date, oran excess-inflation penaltycould be imposed. These modificationswould reduce thepotential for manufacturers toincrease the spread by raisingthe list price rather than cuttingthe acquisition price.

An obvious disadvantage ofany list price, including AWP,is that it may deviate substantiallyfrom actual transactionprice. However, if transactionsprices are monitored quarterlyand the discount percentageadjusted to capture the spread for the payer, as occursin the private sector, the resulting payment level wouldapproximate transactions prices with a lag, and theaudit burden would be less than under a transactionsprice approach. Of course, even if margins are appropriateon average, both positive and negative deviationsare possible for individual products, which could distortprescribing choices. However, this is true for everyadministered pricing rule, whether based on list ortransactions prices, and for diagnosis-related groupreimbursement for hospitals and resource-based relative-value scales for physicians. As long as the rate ofincrease of list prices is constrained, differences in thespread across drugs should reflect differences in manufacturerprice cuts, not in manipulation of the list price.

An alternative list price that appears to be moregrounded in acquisition costs is the WAC. Some statesalready use WAC plus a markup as an option to reimbursepharmacies under Medicaid. The wholesale acquisitioncost is a manufacturer catalogue price towholesalers and is also published by pricing servicessuch as First Data Bank. However, if Medicare were toadopt WAC as a basis for reimbursement, exactly thesame incentives that have distorted AWP would applyto WAC: manufacturers would have incentives to raisethe listed WAC and then to offer discounts below WACto increase the provider's spread. Thus, any manufacturer-determined list price will face the same potentialfor distortion as AWP, unless constrained by an excess-inflationpenalty.

Under a discounted AWP approach with consumerprice index or producer price index constraints, regulationsshould clarify that selling below the list priceshould not be grounds for charges of fraud and abuse.Given the 2 provisions proposed here, that the increasein AWP is constrained and the payer captures thespread by adjusting the discount factor, then any marginbetween the AWP and the actual selling price canbe presumed to reflect competitive discounting and isto be encouraged.

In general, reimbursement to physicians or pharmaciesfor dispensing costs is better done through a fixeddispensing fee, rather than by paying a percentage of thedrug price. Dispensing and overhead costs usually do notvary with the price of the drug. Paying a percentage ofthe drug price encourages use of higher-priced drugs.

Transactions Prices With Markups/Rebates

Setting reimbursement based on a transaction priceplus a markup rather than a list price is intended toground reimbursement more firmly on the provider'sactual acquisition cost. With this objective in mind,starting on January 1, 2005, Medicare will pay for PartB drugs based on ASP plus 6% or a widely available marketprice. A drug's ASP is defined as the average salesprice to all purchasers, excluding certain public purchasers,and is to be reported quarterly by manufacturersto CMS, with significant penalties for misreporting.

The fundamental concern with this approach is thatit undermines manufacturers'incentives to compete onprice. At the limit, if a reduction in price is perfectlymatched by a reduction in reimbursement, the physicianhas no incentive to use the lower-priced drug andthe manufacturer has no incentive to reduce price;rather, the manufacturer may have an incentive toraise price.

This tendency for ASP-based reimbursement, likeany cost-based reimbursement, to lead to price increasesmay be attenuated by 2 factors. First, because reimbursementto all physicians is based on average salesprice, not the physician-specific sales price, the manufacturermay still have an incentive to discount to highlyprice-sensitive physicians. However, this incentive ismuted because ASP is a volume-weighted average price.Second, if private payers continue to reimburse physiciansbased on discounted AWP, then the incentive toraise prices to maximize reimbursement from Medicarepatients may be constrained. However, given Medicare'sdominant market share for most Part B drugs, the likelyeffect of ASP-based reimbursement is to reduceincentives for price competition, leading to higherprices to both private payers and Medicare than wouldoccur under our proposed constrained-AWP-minus-X%,where X% is revised based on actual margins.





The manufacturer's incentives to discount would beslightly less under our proposed flexible discount offAWP rule, compared to the current fixed 5% discount offAWP, to the extent that manufacturers anticipate that adiscount granted in period may lead to a larger reimbursementdiscount off AWP in + 1. However, this negativeeffect on incentives to discount is weak becausethe reimbursement discount off AWP is an average overall products. By contrast, the negative effect on incentivesto discount is much greater under the ASP rule,because each drug's ASP reimbursement in + 1depends on drug-specific discounts in period .

A similar reduction in manufacturer discounts to privatepayers occurred after Medicaid's adoption of theOmnibus Budget Reconciliation Act of 1990, whichrequired manufacturers to give a rebate to Medicaidequal to the greater of 15.1% of average manufacturerprice (AMP) or AMP-"Best Price"to private buyers.10,11

Reference Pricing

Administered pricing rules based on either list ortransaction prices could be combined with internal referencing, whereby Medicare would set a single reimbursementfor all drugs in the designated group.8,12Maximum allowable charge reimbursement for multisourcedrugs, as already used by Medicaid and manyprivate payers, exemplifies generic referencing. Weendorse the MMA's adoption of MAC reimbursementfor multisource drugs under Parts B and D. Genericreferencing offers significant cost savings to payerswithout significant health risk to patients or disincentivefor R&D.

More controversial is therapeutic referencing, whichapplies the same reimbursement to different compoundsin a therapeutic class—for example, all β-blockers—with the reimbursement level usually set at thelowest price in the class. Manufacturers may charge aprice above the reference price, but the patient mustpay the difference. The recent attempt by CMS to reimbursesimilar products (such as Procrit and Aranesp) atthe same rate based on "functional equivalence"is therapeuticreferencing in all but name. If applied to drugsthat are equivalent in all relevant dimensions, thentherapeutic referencing is consistent with cost-effectivenessprinciples; however, if applied without rigorousevidence, then therapeutic referencing may deny paymentfor real improvements in treatments, for at leastsome patients, and undermine incentives for researchin such improvements. Of course, the differencebetween real improvements and minor variations is afine line. However, such judgments should be based onempirical evidence, given their potential effects onincentives for innovation. The MMA prohibits the use offunctional equivalence unless it was in place prior to thelegislation's passage.

Competitive Contracting for Medicare Part B Drugs

Competitive contracting approaches seek to avoidthe need for Medicare to define administered pricingrules. Under a direct purchase approach, Medicarewould procure drugs directly from manufacturers, asdoes the Department of Veteran's Affairs (VA).However, the VA direct procurement model is impracticalfor Medicare. The VA delivers services through itsown, compact provider system. By contrast, Medicareuses the private sector delivery system, includingthousands of private physicians and pharmacies whomust be reimbursed for the drugs that they acquireand dispense.

Under indirect contracting for Part B drugs, asplanned starting in 2006, Medicare will contract withspecialty pharmacies, distributors, or PBMs to contractwith manufacturers, negotiate prices and deliver drugsto physicians. Specialty pharmacies currently handlemost Part B drugs that require special handling, such aspatient-specific dosing and just-in-time delivery tophysician offices; however, chain pharmacies and PBMsare increasingly entering this market. The MMA provisionsfor Part B drugs will thus provide a test—albeit aspecialized one—of the indirect competitive contractingmodel for Medicare drug benefits.

Under the MMA indirect contracting approach, specialtypharmacy contractors for Part B drugs will bereimbursed for a drug at the lowest bid price of anycontractor in the area, plus an administrative fee fordrug handling and delivery. Contractors on Part Bdrugs are not authorized to engage in active formularymanagement and will not be at risk for total drugexpenditures. Whether this indirect contractingapproach, with contractors as passive administrators,can yield acceptable control over drug prices is far fromcertain. The leverage of private sector PBMs in negotiatingdiscounts with manufacturers depends criticallyon their use of tiered formularies to shift market shareto preferred drugs. If Part B drug contractors must offera totally open formulary, undifferentiated by tieredcopayments, manufacturers would have little incentiveto offer price discounts except to the extent that thebeneficiaries'25% copayment creates some price-sensitivityof final demand. If a manufacturer offered discountsto a particular contractor, this might increasethe likelihood that contractor would win the Medicarecontract but would have no effect on patient or physicianbehavior and hence no effect on the manufacturers'market share.

Thus an indirect contracting model with specialtypharmacies/PBMs that lack discretion to design restrictiveformularies is likely to be ineffective at stimulatingprice competition between manufacturers. Suchmanacled indirect contracting is likely to generate lesscompetitive pressure on drug prices than a constrained-AWP-minus-X% administered pricing rule, which preservesmanufacturers'incentives to cut prices toprescribing physicians while capturing much of the savingsfor Medicare, provided that the discount percentageis revised periodically.

In fact, if Medicare adopts indirect contracting withspecialty pharmacies/PBMs but without formularies tocontrol prices, Medicare would probably still have todefine an administered pricing rule in order to determinereasonable reimbursement to the PBM contractorsfor the drugs they procure, if passive pass-through ofdrug prices is to be avoided. Similarly, competitiveselection of intermediaries and carriers to administerhospital and physician services under Parts A and B hasnot relieved Medicare of the need to define administeredpricing rules that these intermediaries apply inpaying providers. An alternative reimbursement rule fordrugs would be to pay the lesser of the lowest indirectcontractor price or constrained-AWP-minus-X%. Underthis approach, Medicare could experiment with competitivecontracting, but would be no worse off thanunder the revised AWP rule.

Competitive Contracting for a ComprehensiveOutpatient Drug Benefit

The MMA gives the PDPs some flexibility in formularydesign for Part D drugs and places them at partial riskfor Part D drug spending. Thus if administration of PartB is merged into Part D, the Part D formulary flexibilityand associated incentives and ability to constrain pricesmay be extended to Part B. However, it remains uncertainwhether PDPs will be willing to participate as riskbearingcontractors if they are required to offer openenrollment despite substantial adverse selection risk,have limited ability to constrain formularies and otheraspects of benefit design, and are limited in their abilityto raise beneficiary co-payments or premiums.However, if PDPs are constrained in benefit design orare only minimally at risk for part of the administrativefee, with drug costs largely passed through toMedicare, then Medicare may again resort to administeredpricing rules in order to limit its expenditures toacceptable levels.

Competitive Contracting for ComprehensiveHealth Benefits

While the viability and efficiency of a stand-aloneMedicare drug benefit administered through competingPDPs remain highly uncertain, less doubt existsthat competing health plans can bear risk for thecomprehensive set of healthcare benefits, includingoutpatient and Part B drugs. Admittedly, theMedicare+Choice program has experienced slowgrowth and plan withdrawals over the past few years,for reasons that are beyond the scope of this report. Amore promising model is the Federal EmployeesHealth Benefit Plan, run by the Federal government forits own employees.

The advantages of competitive contracting for comprehensivehealth benefits, rather than contractingonly for stand-alone pharmacy benefits, let alone forPart B drugs only, is that comprehensive contractingallows the government to harness the health benefitexpertise of private insurers in an integrated, competitivebidding premium model that may, over time, createefficiencies and savings in both benefit costs andadministration. Competitive contracting places privateplans in the role of negotiating reimbursement fordrugs and other medical services, eliminating the needfor administered pricing rules by Medicare. By removingthe silos associated with current Medicare funding,contracting for comprehensive health benefits mayenhance incentives and opportunities for savings inhospital or physician services that may result fromadding comprehensive drug coverage.


We view contracting for comprehensive health benefits,including both comprehensive outpatient drugcoverage and current Part B drugs, as the most attractivemodel. Contracting for specific services separately—hospitals, physicians, or prescription drugs—isproblematic, because of the distorting incentive effectsof silo reimbursement and because Medicare cannotavoid setting pricing rules, either directly or indirectly,if it must determine reasonable reimbursement tothe intermediaries who administer the program. Notsurprisingly, Medicare has tended to adopt administeredpricing rules, as the least bad alternative comparedwith passive cost pass-through. A similaroutcome seems likely if Medicare seeks to contractindirectly for Part B drugs and even the Part D drugbenefit.

If administered pricing rules are to be used, the leastproblematic are those that pay a flexible discount off ofa constrained list price, such as inflation-constrainedAWP minus a discount percentage that is adjusted periodically.This discounted list price approach shouldcreate the strongest incentives for price competition bymanufacturers and capture some of the resulting savingsfor Medicare, with a lag. Although basing reimbursementon a transactions price—such as MMA'sASP approach for Part B drugs—might seem moregrounded in actual acquisition costs, this approach islikely to increase manufacturer prices for both privateand Medicare patients.

Direct competitive procurement by Medicare isimpractical. Indirect competitive bidding, usingPDPs/PBMs to negotiate prices with drug manufacturers,is likely to be ineffective unless the intermediariesare empowered to use formularies with tieredcopayments and can keep a share of discounts negotiated.If these intermediaries are reimbursed fordrug costs and administration, without bearing significantupside or downside risk, then Medicare mayresort to an administered pricing rule based on AWPor ASP, to evaluate the reasonableness of the pricesthat it pays for drugs.

Similar conclusions may apply to competitive contractingfor the Part D benefit, although the Part D PDPsare more likely to be able to use restrictive formulariesand be at some financial risk, thus increasing their abilityand incentives to constrain prices to acceptable levels.However, the viability of stand-alone PDPs remainsuncertain. The efficiency of competitive contracting forboth Parts B and D may improve by being combined.Under MMA, CMS was to report to Congress on the feasibilityof merging Part B into Part D in January 2005(report unreleased as of February 3, 2005). Althoughissues such as differing co-insurance requirements willstill need to be resolved, the stakeholder role of physiciansin Part B will likely diminish, assuming that theshift to a 15% discount off AWP and then to ASP-basedreimbursement reduces physicians'incomes from dispensingPart B drugs.

Competitive contracting for comprehensive healthbenefits would reduce many of the problems encounteredin contracting for stand-alone drug benefits.Medicare would not need to define administered pricingrules for drugs or for other services. And Medicareand beneficiaries would benefit from integration ofservices, rather than silo-based reimbursement andmanagement of drugs and other medical services.The Medicare Advantage program, if more successfulthan the Medicare+Choice program, would resolvemany of Medicare's problems of devising payment rulesfor drugs.

From the Departments of Health Care Systems and Insurance and Risk Management,The Wharton School, University of Pennsylvania, Philadelphia, Pa (PMD); Project HOPE,Bethesda, Md (GRW); and Patton Boggs LLP, Washington, DC (KEM).

This research was supported by a grant from Aventis Pharmaceuticals, Bridgewater, NJ.The views expressed are those of the authors and do not necessarily represent the viewsof the research sponsor.

Address correspondence to: Patricia M. Danzon, PhD, Chairperson, Department ofHealth Care Systems, The Wharton School, University of Pennsylvania, 204 ColonialPenn Center 3641 Locust Walk Philadelphia, PA 19104-6218.

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