Government regulated or negotiated drug prices: Key design considerations
August 30 2021

Editor’s Note: This analysis is part of the USC-Brookings Schaeffer Initiative for Health Policy, which is a partnership between Economic Studies at Brookings and the University of Southern California Schaeffer Center for Health Policy & Economics. The Initiative aims to inform the national health care debate with rigorous, evidence-based analysis leading to practical recommendations using the collaborative strengths of USC and Brookings. The Commonwealth Fund has provided a grant to the Brookings Institution to support the work on which this post is based.

Americans pay much higher prices for brand drugs than do people who live in other industrialized nations.  Most Americans—79 percent—consider U.S. prescription drug prices to be unreasonable, with almost 3 in 10 reporting they go without prescribed medications because of cost. With 70 percent of Americans reporting that lowering drug costs is their highest health care priority, the Congress and the Biden Administration are considering how to lower US drug prices.

 Having the federal government lower drug prices directly—whether by negotiating with manufacturers or unilaterally setting prices—would save money for governments, employers, and consumers, but constitute a major policy initiative that turns away from reliance on market forces. Because of high U.S. prices, drug companies generate an estimated three-quarters of worldwide drug company profits in the United States.  That means not only that U.S. consumers pay a lot, but also that reducing U.S. drug prices would lower manufacturer revenue and return on investment, likely cutting funding for development of new drugs, with a slowing of innovation.  

Members of Congress have introduced several bills to curb drug prices.  The most important, in our view, is H.R. 3, the Elijah E. Cummings Lower Drug Costs Now Act, which passed the House in late 2019 but was not taken up by the Senate.  It sharply expanded the boundaries of drug pricing reform discussions by authorizing the Secretary of Health and Human Services (HHS) to set drug prices for both government and commercial payers through a combination of formulas and negotiation and imposed prohibitive tax penalties on pharmaceutical manufacturers that did not accept the government price. Importantly, H.R. 3 would have the government control what manufacturers can charge for their drugs—regulated prices—which deviates from the more traditional approach of establishing what public payers like Medicare will pay for drugs—administered prices. Reflecting the expanded scope of drug pricing reform issues, this blog explores six key policy choices that any measure to rein in drug prices directly would have to address, either through legislation or regulation. 

  1. What process should HHS use to set the price for a drug?
  2. Will the new system set prices only for a limited number of high-cost drugs that lack therapeutic alternatives or more broadly by including drugs that compete with other medicines?
  3. Does the specified price represent the actual price for all sales of a drug, or is it a “ceiling” price, with payers retaining the ability to negotiate lower prices?
  4. Will drug prices set by HHS apply to a narrow or broad population (e.g., only Medicare Part B or Part D beneficiaries or all patients, regardless of their insurance coverage)?
  5. How would HHS assess and incorporate the value of a drug when establishing its acceptable price?
  6. How should HHS select drugs for lowered prices?
#1.  Process and Authority for HHS When Setting the Price for a Drug

Legislation directing HHS to negotiate drug prices with manufacturers needs to specify what happens if the parties fail to agree.  Without this authority, negotiation is unlikely to lead to lower prices.   Three different approaches can be used to set lower prices for high-priced drugs when negotiation does not produce an agreement: (i) HHS could unilaterally set prices, (ii) HHS could establish prices through notice and comment rulemaking, or (iii) an independent arbitrator could set prices. Although frequently characterized as establishing negotiation, H.R. 3 effectively empowers HHS to set permissible prices between a floor and ceiling, where the floor equals the lowest-price among the six specified countries and the ceiling equals 120 percent of the average rate across the six countries.  Negotiation can occur, but only within that range, with the penalty for not accepting the HHS-established price causing the manufacturer to “pull a particular drug out of the U.S. market entirely.”

Unilateral HHS Authority to Set Prices

The simplest, least complicated approach to setting a regulated price would empower HHS to unilaterally decide without requiring a formal process or imposing specific criteria.  The Secretary would have the discretion to consider, as appropriate, the information and positions exchanged during the initial negotiation stage, as well as any expert analysis HHS might choose to consider. HHS would have broad discretion, including whether to establish procedures for public comment by stakeholders such as manufacturers, beneficiary organizations, insurers and employers. In addition, the legislation could provide guidance to HHS, potentially limiting its discretion by specifying factors which might argue for a higher or lower price within the permitted range.

HHS Sets Prices through Notice and Comment Rulemaking

To administer Medicare, HHS routinely uses notice and comment rulemaking to set prices for specific categories of hospital admissions, physician services, and those provided by many other providers. The rule-making approach would impose procedural requirements based on the Administrative Procedures Act (APA) that govern how HHS exercises its decision-making authority. Formal rulemaking provides for input by multiple stakeholders and others through comments on the proposed rule, and HHS must respond to submitted comments in its final rule. Should this approach be chosen, the legislation could require publishing the proposed and final drug prices either in the Federal Register or be issued by CMS on its website, as is currently the case for the annual proposed and final payment notices for Parts C and D, involving Medicare Advantage and prescription drug plans. To speed up the process, the public comment period could be shortened to less than the typical 60 days used for Medicare.

The statute could require HHS to issue regulations establishing an overall framework, programmatic goals and decision criteria that would guide decisions and constrain how the Secretary exercises discretion. Although courts typically defer to the Executive Branch in rulemaking, the APA requires HHS to justify its proposal, limiting arbitrary and capricious actions. In its initial notice, HHS would specify the proposed price for each designated drug along with the relevant data and analysis. The HHS final announcement would publish the drug prices after considering public comments, as required by the APA. The White House Office of Management and Budget (OMB) would review proposed and final actions. In drafting the legislation, the Congress should decide whether to exempt these price decisions from judicial review, a provision adopted in past payment reform legislation that would limit the ability of manufacturers to challenge (and delay) implementation of the government-set prices.

Independent Arbitrator Sets Prices

If legislation requires that prices be set through arbitration, it could specify who arbitrates: whether the arbitrators are federal employees or private parties, whether there is a single arbitrator or a panel, and how arbitrators are chosen.  In addition, the arbitrator could be authorized to set the price anywhere within the ranges proposed by the government and pharmaceutical companies or required to decide which party prevails and select the price that party proposed (called “final offer arbitration”).  An advantage of the latter is that it motivates both sides to submit reasonable bids, which, it is hoped, narrow the differential in proposed prices.

Either way, legislation should list factors that arbitrators should consider in making their decision.  This was done in the recent legislation addressing surprise medical billing, which established a norm—median in-network payment rate in the area—and indicated what factors might be considered by arbitrators to justify a higher or lower rate.

Arbitrators could be federal employees who are charged with acting independently or they could be professional (non-federal) arbitrators. Two potential federal models are the Medicare Provider Reimbursement Review Board (PRRB) and Administrative Law Judges (ALJs). PRRB members are appointed by the Secretary to a three-year term, have appropriate education and professional expertise, and are subject to federal ethics rules. Created by the APA in 1946, ALJs serve “as independent impartial triers of fact in formal proceedings requiring a decision on the record after the opportunity for a hearing” and must pass a competitive examination as well as meet education and experience requirements. Manufacturers might have concerns that, despite safeguards intended to protect their independence, federal employees would tend to favor HHS.

The private sector relies heavily on “alternative dispute resolution” approaches, including a variety of arbitration organizations, such as the American Arbitration Association. As a matter of public policy and accountability, objections could arise about having private individuals make decisions that are arguably inherently governmental, including determining spending by taxpayers in programs like Medicare and Medicaid. In addition, the appearance of conflicts of interest and perceived bias might arise because private arbitration organizations, whether not-for-profit or for-profit, and the individuals they employ or contract with have an interest in securing future arbitration assignments. For example, if the federal government were to create a roster of approved arbitrators and private parties had a hand in selecting them, repeat business could be steered to arbitrators perceived as being more sympathetic to one side or the other.[1]

#2. Scope of HHS Pricing:  Types of Drugs

Drugs and biologics fall into one of three categories:

  • Medicines currently without competition, which occurs when an innovator has both market exclusivity and there are no therapeutic alternatives.
  • Medicines where multiple products compete by providing therapeutic alternatives for treating a condition (notwithstanding market exclusivity for each innovator).
  • Generic drugs with robust competition.

Drugs differ from biologics in that the former are small molecules produced by chemical synthesis, while biologics are large, complex molecules produced by living organisms. The size and complexity of biologics typically limits the Food and Drug Administration (FDA) to approving biosimilars as similar but not identical to innovators, which requires a prescriber to substitute a biosimilar for a biologic. In contrast, FDA approval of generics as equivalent (“therapeutic substitutes”) to brand drugs allows substitution by pharmacists.

Medicines without Competition

Unlike other nations, the U.S. lets manufacturers of drugs and biologics set whatever price they choose.  For drugs with market exclusivity and without therapeutic alternatives, the dearth of competition and the pervasiveness of insurance mean that lowering U.S. prices significantly requires government intervention. U.S. drug prices for brand drugs average almost 3.5 times prices in OECD countries overall and averaged almost twice prices in Canada, United Kingdom, Germany, or France. Examples of high-priced U.S. drugs that lack meaningful price competition include many biologics, oncology treatments (including immunotherapies), and “orphan drugs” which receive longer periods of exclusivity in exchange for targeting narrow patient populations.

Brand Medicines with Therapeutic Alternatives

Many of the almost 400 million annual outpatient prescriptions for brand medicines are subject to some competition from therapeutic alternatives, which are clinically similar but not chemically identical products (unlike generics). Therapeutic alternatives can range from different molecules that yield clinically similar treatments, making them broadly substitutable, to different molecules that treat the same condition but differ in clinically significant ways. 

Having HHS limit prices for drugs with therapeutic alternatives would substantially increase the number of medicines impacted by the price limits. An important part of the gap between U.S. prices and those in other high-income countries involves drugs with therapeutic alternatives, as shown with drugs that cure hepatitis C infections (see box).

Drugs that cure hepatitis C constitute a true clinical breakthrough for a serious disease with a large infected population, but suggest the limits of market-based competition. Hepatitis C treatments quickly became multi-billion blockbusters for Gilead Pharmaceuticals and, despite significant declines in U.S. prices since 2014, treatments remain costly, with much higher prices than in other countries. Even after the introduction of five non-Gilead therapeutic alternatives starting in 2017, U.S. prices for a course of treatment remain substantially higher than in other OECD countries, including Japan, Korea, Britain, and Germany. In 2017, the price of the drugs ranged from $94,000 (a list price, with net prices possibly averaging about half) to a low of about $50, with reported costs of $5,000 in Korea but $300 in Japan and India.

Generic Drugs

Generics constituted 90 percent of the 3.8 billion retail prescriptions dispensed in the U.S. in 2019, of which 92 percent were filled for $20 or less, and totaled only 20 percent of $370 billion in retail drug spending. Replacing the highly competitive market for generics with an administered or regulated price system is unlikely to lower generic prices, a conclusion buttressed by U.S. generic drug prices averaging 84 percent of generic prices in other Organization for Economic Cooperation and Development (OECD) member nations. 

#3.  Price Set by HHS for a Drug: a Price for All Sales or Can Payers Negotiate Lower Prices?

If allowed to negotiate lower-than-ceiling prices, insurers and pharmacy benefit managers (PBMs) would steer patients and prescribers to preferred drugs through restrictive formularies, differential cost-sharing, and utilization management tools like prior authorization and step therapy. Unlike requiring drugs to be sold at a uniform price, allowing drug prices to be at or below the ceiling would permit payers to negotiate lower prices with manufacturers. Manufacturers would likely trade-off lower prices for increased volume when that boosts net revenues, but deeply cutting permissible prices would constrain the range between manufacturers’ most and least discounted prices.

Manufacturers negotiate post-sale discounts—rebates—based on a payer’s ability to shift utilization to their drug and away from therapeutic alternatives made by competitors, with financial terms typically linked to payers meeting volume targets. For some drugs, rebates are a large percentage of list prices, which poses a problem because patient cost sharing is commonly based on published list prices rather than lower, after-rebate prices. As a result, patients using highly-rebated drugs pay a disproportionate share of the actual cost because Medicare Part D and many employer-based plans apply rebates to reducing monthly premiums charged all enrollees instead of linking what patients pay to net prices. Unless HHS bans rebates or limits the use of tools to steer utilization, list and actual (net) drug prices would continue to diverge. In Medicare Part D, to assure patients share proportionately in rebates, legislation would have to link cost-sharing to approximations of net prices.

Requiring government-set prices to be uniform prices at which drugs are sold would limit reliance on tools such as prior authorization and multi-tiered formularies, potentially reducing the practice of managing drug use for economic (rather than clinical) reasons.  Discouraging such practices would reduce provider hassle and lower administrative costs of health plans and physicians, which are currently estimated at $33 billion annually. Limiting the ability of plans and PBMs to steer volume in exchange for negotiated discounts would enable manufacturers to maintain high prices on drugs without regulated prices unless the government establishes uniform prices for many more drugs than if HHS sets ceiling prices. Unfortunately, distinguishing utilization management intended to lower prices versus clinically-based interventions (e.g., to avoid inappropriate prescriptions or minimize use of low-value drugs) promises to prove difficult in practice.

#4.  Scope of HHS Pricing:  Types of Patients

A critical policy choice is whether regulated prices apply narrowly (e.g., to Medicare) or broadly (e.g., to all payers and patients)? To state the obvious, narrowly imposing regulated prices would not lower drug prices for those who pay for private insurance and non-Medicare consumers paying a portion of drug costs at the point of sale, but it would also limit the revenue loss for drug companies. Conversely, applying regulated prices broadly across the population would lower drug costs for most Americans and payers, while magnifying the revenue loss for manufacturers. Arguably, the precedent of regulating drug prices, even if imposed relatively narrowly, might have a chilling effect on innovation and private investment in drug development.

The federal government has established rebate-based administered price programs that steeply discount reimbursement received by manufacturers for drugs dispensed to low-income patients and safety-net providers. While intended to reduce burdens on states and providers that treat many low-income patients, these policies skew drug prices for other payers and distort incentives for manufacturers and some providers. The rationale for maintaining the Medicaid rebate, “best price” and 340b programs is open to question if regulated prices directly lower drug prices.

#5.  Basis for Valuing a Drug when HHS Sets its Price

A government program could set the price of a drug based on either the significantly lower prices in other high-income countries or the “value” of the drug, based on health benefits or treatment-cost savings in relation to the drug price.  Given the complexity and uncertainty of setting prices or establishing value, a legislatively specified range for HHS prices would simplify implementation and speed savings for patients, payers, and taxpayers. 

Linking U.S. Prices to Ex-U.S. Prices

If the U.S. government sets prices based on currently lower prices abroad, drug manufacturers would have an incentive to raise prices in the comparison countries because the U.S. market, with 330 million potential customers, dwarfs the number of customers in other individual high-income countries. Manufacturers would have incentives to raise prices in those countries whose prices were used as a reference to diminish the potential for lower ceilings for prices in the U.S.  This is most pronounced for those drugs without therapeutic alternatives.  For those with alternatives, incentives to no longer discount prices in reference countries could be substantially weaker.  In those cases, substantial increases in prices would lead to substantial losses of volume since competitors whose brands had not been chosen for a review of their prices would have no reason to change prices.

Determining what foreign prices actually are poses additional challenges.  To avoid having their prices rise, countries might permit manufacturers to increase nominal—but not actual—prices, further complicating the ability of HHS to learn the actual level of prices. In addition to raising either actual or reported prices, manufacturers could limit revenue loss in the U.S. market by delaying launch or not selling drugs in selected countries. However, to prevent impaired access to important medicines, nations will act to protect the health of their residents, which could potentially include allowing other manufacturers to produce brand drugs, vitiating patent protections. Many of these problems could be avoided by using past prices rather current prices abroad to set ceilings in the United States.  Rather than rebasing the link to prices abroad in future years with more recent sales data, the historical prices could be updated using a suitable index of drug price inflation, which might reduce or eliminate incentives to seek higher prices abroad or to end sales to selected countries.

Other countries typically rely on a single payer or decision-maker to set the price of a drug, frequently reflecting an assessment of a drug’s value. Pegging U.S. prices to prices abroad would have the effect of importing judgments made in other countries about the value of medications and the importance of patient access, reflecting those citizens’ preferences about choice and spending. U.S. patients, political leaders, and payers such as employers might object, because their preferences regarding choice, access, and spending might differ from those of decision makers abroad, with Americans likely being willing to spend more for improvement in health outcomes than those in the reference countries.  But they might find such reference pricing to be useful temporarily as a short-term bridge, allowing time to develop a domestic process for assessing value and pricing. 

Basing Drug Prices on Value

Incorporating value into drug pricing involves two distinct functions: researching effectiveness and costs, and using the findings to inform how much to pay for drugs. But differences between recent notions of value in health care and economists’ use of the term generally could result in inaccurate or excessive prices (see box).

The term “value-based pricing” is currently used in many health care discussions without a precise definition of what the term means, frequently relying on a vague notion of what the term means.  The essence is there may be a threshold at which improvement in outcomes are too small to justify the expense for a particular treatment.  Different societies will come up with different thresholds reflecting their willingness to sacrifice other goods and services for improvements in health.  Economists, on the other hand, have developed very precise notions of value, which involve how much more a buyer would have been willing to pay for a good or service than the market price.  In a classic example, the first gallon of water per day that a person consumes would be extremely valuable (drinking to sustain life) but the 1000th gallon per day, for example watering a lawn, washing a driveway or filling a swimming pool, would have value not much above the price.  Markets set prices on the basis of how value of the last units compare to marginal costs.  At best, effectiveness research likely is capable only of estimating the value on average for all of the units of a service or a drug combined.  Under a system determining price on the basis of value, confusion about the average patient versus the patient who gains the smallest improvement in outcomes could lead to inadvertent but substantial overpayments to manufacturers. A further complication arises because of concerns about limitations associated with the most widely-used metric of value, quality-adjusted life-years (QALYs). 

While federal employees, contractors, or a mix of intra- and extramural experts could conduct cost-effectiveness research, establishing the HHS price for a drug appears to be an “inherently governmental” function that needs to be decided by federal employees rather than private parties under contract. Drug pricing legislation directing HHS to base drug prices on cost-effectiveness analysis could specify key parameters, including whether HHS would perform the analysis using federal employees or contract with private entities. With sufficient lead time, the federal government could develop the capability and perform cost-effectiveness analyses, despite constituting a sharp departure from current policy prohibiting Medicare from using comparative clinical effectiveness research by the Patient-Centered Outcomes Research Institute (PCORI).

Since at least the “Reinventing Government” initiative in the 1990’s, the federal government has increasingly relied on “contracting out” to private organizations, such as universities or independent research institutes, rather than hiring government employees to conduct in-house research and analysis. While the nature of cost-effectiveness analysis differs markedly from the scientific research funded by the National Institutes of Health (NIH), NIH combines extensive extramural and intramural research. Having a mix of in-house and contracted researchers increases federal capability and flexibility, as well as enabling evaluating each approach over time. Given the importance of the analysis and its effect on federal spending, a robust in-house capability would seem essential to set priorities and criteria, select vendors, and oversee the work of contractors. Government employees, working with expert advisory panels, could decide which organizations to fund.

The U.S. organization most experienced with this type of research is the Institute for Clinical and Economic Review (ICER).  ICER studies effectiveness and makes recommendations about which technologies (drugs or others) have enough effectiveness to justify their costs.  Both insurers and manufacturers fund the organization’s analyses, which often involve drawing on or conducting research to estimate improvements in patient outcomes from particular treatments, using measures such as quality-adjusted life years (QALYs), and comparing them with the costs of the treatment.  ICER recommends coverage for treatments with low costs per QALY and against those with high costs per QALY. Even though ICER may have the most experience with this type of analysis, the government would benefit from funding additional private organizations, creating redundant capacity among competing entities that would strive to improve cost-effectiveness analysis. 

An attractive alternative might involve creating one or more Federally Funded Research and Development Centers (FFRDC), which are nonprofit organizations with long term contracts with federal agencies to provide research and development services critical to its mission.  The approach goes back at least as far as the 1940s, when the U.S. Air Force created the RAND Corporation to conduct long-term strategic studies.  A health care example is the CMS Alliance to Modernize Health Care (Health FFRDC), which is operated by Mitre, an organization that operates FFRDCs for the U.S. government in a wide range of areas.  FFRDCs often subcontract some of the work to other private organizations to gain flexibility to respond to changing federal needs and to reach the scale needed to meet the agency’s needs.

Creating and maintaining a robust capability to achieve large, sustainable reductions in drug prices requires adequate, predictable funding to sustain these activities. To avoid having this funding needing to compete in the annual appropriations process, drug pricing legislation could appropriate multi-year funding, similar to the funding for PCORI and the Centers for Medicare and Medicaid Innovation (CMMI).

#6.  Drugs Selected by HHS for Setting Lower Prices

Choices concerning which drugs to review for the establishment of ceiling prices have important implications for the amount of money saved, patient outcomes, and effects on innovation.  H.R. 3 would require HHS to select at least 25 drugs in 2024 and 50 in subsequent years from among the 125 drugs that account for the highest spending nationally or in Medicare.  Even with authority to review more drugs, staffing, financial resources, and complexity of the process would constrain HHS capacity. As we explained in Section #3, setting a ceiling price for one drug and allowing payers to steer volume would likely reduce net prices for therapeutic alternatives substantially and could generate significant savings, while also limiting the number of drugs for which HHS would have to set prices.

HHS could use additional criteria in determining what drug prices to set.  For example, it could target drugs that have had high prices for a long time and which face no meaningful competition. Focusing reviews on drugs that have been on the market past the normal periods of exclusivity would address extensions based on activities that have been labeled as abuses of the patent system, such as patenting minor changes in drugs or paying other manufacturers to delay generic entry.   HHS might announce an intention not to regulate prices for some period when future drugs provide significant clinical advances, a step that would encourage innovation and the development of breakthrough and novel drugs.  In addition, investors in drug development might be more sensitive to expectations about pricing during the early years that a drug is on the market than the later years. Another potential criterion for selecting drugs for price setting would be if a drug’s price is very high in relation to its improvements in patient outcomes.  Concentrating price cuts on low-value treatments while allowing more generous pricing for high-value drugs would encourage development of drugs that make a real difference in patients’ health.  In addition, HHS might focus on drugs with net prices well above prices abroad despite the existence of therapeutic alternatives or biosimilars. This criterion might lead to large price reductions on some physician-administered drugs, facing market forces weaker than those facing drugs dispensed at retail pharmacies. 


[1] The issue of referrals and influence could quickly become quite complicated, if drug price arbitrations were only one line of business, with other arbitration referrals being driven by, for example, health plans or providers, as well as pharmaceutical manufacturers.

About the Authors

Paul B. Ginsburg

Paul B. Ginsburg

Nonresident Senior Fellow – Economic Studies, USC-Brookings Schaeffer Initiative for Health Policy
Steven M. Lieberman

Steven M. Lieberman

Nonresident Fellow – Economic Studies, USC-Brookings Schaeffer Initiative for Health Policy

Disclosures: The Brookings Institution is financed through the support of a diverse array of foundations, corporations, governments, individuals, as well as an endowment. A list of donors can be found in our annual reports published online here. The findings, interpretations, and conclusions in this report are solely those of its author(s) and are not influenced by any donation.

Acknowledgments: The authors would like to thank Henry Aaron for his helpful comments.