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Drug Rebates
USC-Brookings Schaeffer on Health Policy

Sharing drug rebates with Medicare Part D patients: Why and how

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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. This post originally appeared in Health Affairs on September 14, 2020.

High prescription drug prices are often cited as a key concern in public opinion polls; what patients pay frequently reflects a drug’s list price, which excludes discounts and rebates. Unlike list prices, which have increased 5 percent to 10 percent annually for branded drugs over the past five years, actual or “net” drug prices have risen only by 0 percent to 3 percent annually. The discrepancy between the average increases in list and net prices reflects the rapid growth in rebates, which lower only net prices. Rebates are discounts paid by drug manufacturers after a prescription is dispensed to insurers, pharmacy benefit managers (PBMs) and, in the case of generic drugs, pharmacies (either directly or through their purchasing agents).

By basing what they reimburse—but not what patients pay—on net prices, health plans save money. In Medicare Part D, the mounting gap between list and actual prices has increased drug costs for patients and diluted the value of their insurance, while lowering monthly premiums for beneficiaries.

High drug prices continue to attract considerable attention from federal policy makers. In the past year, the House has passed (with predominantly Democratic support) major reform legislation to markedly lower drug prices (H.R. 3), and the Senate Finance Committee has reported (with bipartisan support) the Prescription Drug Pricing Reduction Act of 2020. More recently, President Donald Trump on July 24, 2020, signed four executive orders described by the White House as intended to reduce prescription drug costs. One executive order raises the prospect of sharing rebates with Medicare Part D beneficiaries at the pharmacy counter in the hope of reducing patients’ out-of-pocket spending on prescription drugs.

Drug rebates have increased considerably over the past decade, sometimes reaching 50 percent or even more of list price. The percentage of total Medicare Part D drug spending offset by rebates on branded drugs increased from 11.3 percent in 2010 to 25.0 percent in 2018. As required by Medicare, insurers have in turn reduced Part D monthly premiums by the rebates they collect, which in 2018 totaled $24 billion and represented the difference between higher (pre-rebate) list and lower (post-rebate) net prices. (Tables IV.B8 and IV.B.10: Medicare requires data to be reported on manufacturer rebates paid to insurers and PBMs but not to pharmacies, which results in the collection of rebate data for branded but not generic drugs.) Applying rebates to reduce premiums saves an equal amount for all enrollees, but basing cost sharing on the list price of drugs (as is done in Part D) increases out-of-pocket costs for those using drugs with rebates, especially for those patients taking highly rebated drugs.

In addition to raising costs for this subset of beneficiaries, the trend of increasing both list prices and rebates also dilutes the value of Medicare coverage to beneficiaries, so that Part D provides less financial protection. That is because the Part D standard benefit design includes patient cost-sharing parameters that generally reflect pre-rebate drug prices—either directly or through an actuarially equivalent plan design. Over time, as rebates have grown but these cost-sharing parameters have continued to reflect pre-rebate prices, patients have paid a higher share of net drug spending in aggregate, reducing the value of the Part D benefit overall.

Requiring that plans and PBMs share rebates with Medicare Part D patients at the pharmacy counter—first put forth last year by the Department of Health and Human Services (HHS) and the HHS Office of Inspector General and suggested in the recent executive order—raises stakeholder concerns about increased drug prices and federal spending. In this post, we describe how the growth in rebates has affected Medicare Part D patients and analyze approaches to address the issues, explaining how some of the challenges in the Medicare program differ from the challenge in commercial insurance, where some major steps have already been taken. We recommend that legislation require that an approximation of the rebate amount for a drug is credited to patients.

Rebates And How Drug Claims Are Paid

When insured patients obtain prescription drugs at pharmacies, claims to insurers are typically processed in real time at the point of sale, much like a purchase using a credit card. The pharmacy receives confirmation regarding the patient’s insured status, that the drug is covered, whether any special requirements (such as prior authorization) apply, and how much the patient needs to pay out of pocket. These arrangements generally work well for patients, except when beneficiary cost sharing is based on undiscounted prices and rebates are substantial.

Attempts to ensure that rebates are passed on to consumers face three challenges. First, manufacturers and PBMs (who negotiate on behalf of health plans) regard the terms of rebate agreements as confidential trade secrets. Second, the exact amount of a rebate frequently reflects actual performance computed after the end of a specified period (such as a quarter or year), making the contractually specified amount not known when a prescription is dispensed. Third, antitrust authorities such as the Federal Trade Commission (FTC) have a long-standing position that transparency regarding actual prices will impair competition, facilitate collusion, and result in higher actual prices.

In Medicare Part D and many commercial health plans, rebates do not reduce the amount paid by an insured patient who uses the drug, flowing instead as an aggregate payment to the PBM, which in turn passes all or some of the amount on to the insurer. In a competitive market, these payments to issuers and PBMs will be passed on to consumers in some form. Specifically, rebates can be allocated to only lower premiums, to only reduce what patients pay, or to partially lower both premiums and cost sharing.

The Problem

Consider four examples in which a manufacturer doubles the list price of a drug, from $500 to $1,000, but also newly negotiates a 50 percent—$500—rebate with a PBM. The PBM shares that rebate with the insurer, so the net price to the insurer before considering beneficiary cost sharing is unchanged at $500. In the first case, assume patient cost sharing is set at a certain number of dollars per prescription—such as a fixed $35 copayment—with no deductible; the change in list price from $500 to $1,000 would change neither what the patient pays ($35) nor the plan cost after accounting for both the new rebate and the beneficiary contribution ($465). Assume in the second case that the patient’s insurance has coinsurance (for example, 25 percent) based on increased list prices with no deductible, rather than a fixed copayment; the patient payment would double, from $125 to $250.

In a third case with a deductible of $1,000 or more (and no subsequent cost sharing), beneficiary cost would increase from $500 to $1,000. In a fourth case with the $435 deductible and 25 percent cost sharing that are standard in Part D, beneficiary out-of-pocket costs would increase by $125, from $451 to $576.

In all but the first case of a fixed copayment and no deductible, the cost to the insurer would fall significantly: by $125 in the second, 25 percent coinsurance case; by $500 in the third, high-deductible case; and $125 in the fourth, standard Medicare Part D case. Higher list prices increase what patients pay out of pocket and reduce plan spending by an offsetting amount, reducing premiums in Part D. Patients using expensive, highly rebated drugs pay significantly more, while healthy enrollees save money from the reduced premium. In addition, increasing list prices exposes beneficiaries to more risk and reduces the comprehensiveness of insurance coverage.

These simplified examples illustrate what has happened in Medicare Part D over the past decade. Medicare patients using highly rebated drugs have paid substantially more than they would have if list prices and rebates had not increased rapidly. Our analyses suggest these dynamics have led to about half of Part D beneficiaries who do not receive low-income subsidies (non-LIS) paying more out of pocket than they would if cost sharing were instead based on net price, with about 20 percent paying more than $100 extra per year. (The LIS insulates eligible beneficiaries from high drug prices by having Medicare—not patients—pay most or all cost sharing.)

Effect Of Higher List Prices On Medicare Part D Costs

It is possible that rising list prices matched by rising rebates have also increased federal spending on Medicare Part D but determining the spending impact is challenging. Rising list prices lead to beneficiaries getting more quickly to the donut hole and then to catastrophic benefits, where Medicare pays 80 percent of drug spending. In fact, we find that 36 percent of non-LIS beneficiaries who reached catastrophic coverage in 2017 would not have done so had cost sharing been based on net rather than list prices, which would have reduced federal reinsurance spending on the non-LIS beneficiaries by 19 percent. But the complex way in which federal spending on Part D is determined makes the net effect of rebates on federal Part D spending unclear and beyond the scope of this post.

However, the fact that Part D beneficiaries tend to prefer plans with low premiums creates a strong incentive for PBMs to favor drugs with large rebates, since those rebates enable Part D plans to reduce premiums. Thus, instead of creating incentives for plans and their PBMs to prefer drugs with the lowest net cost, the current system instead favors drugs with high rebates. In turn, this creates a system of incentives that can lead to higher drug spending overall.

Why A Solution Is Complicated

While sharing rebates with patients at the point of sale would address these distortions, doing so could increase Medicare Part D premiums, described in projections by the Congressional Budget Office (CBO) and the Centers for Medicare and Medicaid Services (CMS) Office of the Actuary, which reportedly dissuaded the Trump administration from pursuing initiatives either to ban rebates or share them proportionately with patients. (The details of the recently issued executive order to pass rebates to Part D beneficiaries, which require that neither premiums, federal spending, nor patients’ total out-of-pocket costs be increased by the policy, are contrary to findings by the CBO and the CMS Actuary—the official government scorekeepers. As a result, the executive order might be more about symbolism than actually achieving lower drug prices.) Even though beneficiaries might be better off from a combination of higher premiums, lower cost sharing, and more comprehensive insurance, this might be a hard sell due to the certainty of all enrollees paying modestly more in increased monthly premiums versus the uncertainty of some beneficiaries potentially paying significantly more in cost sharing for highly rebated drugs with high list prices.

Apart from concerns about the impact of increasing average Part D premiums, either change—banning rebates or mandating that they be visible to share with patients—could increase drug costs by having increased price transparency facilitate price collusion as well as limiting payers’ negotiating power to link lower prices from a drug manufacturer with higher sales volume. On the other hand, some analysts have projected that banning or mandating the sharing of the precise amounts of rebates at the point of sale could reduce drug costs by enhancing incentives to build formularies around drugs with the lowest net cost.

Current rules require Part D plans to reveal the point of sale or list prices of each of their drugs. This occurs because the Medicare statute splits the Part D benefit into four different segments, each of which has specified cost-sharing requirements. The first part of the benefit includes the amounts below the deductible. The second part starts at the deductible and ends at the “initial coverage limit.” The third part of the benefit (the donut hole) starts at the initial coverage limit and ends at the catastrophic threshold. The final part of the benefit includes all spending above the catastrophic threshold.

For standard, non-enhanced Part D plans, coinsurance must equal exactly 25 percent of a drug’s price above the initial coverage limit (part three above) and 5 percent of a drug’s price above the catastrophic threshold (part four above). This makes it easy to reverse engineer drug prices—simply by multiplying the 25 percent coinsurance by four (or the 5 percent coinsurance by 20). Thus, either banning rebates or sharing them with patients would reveal net prices, which could lessen competition and facilitate price collusion: A lack of price transparency benefits health plans and PBMs because manufacturers are more likely to offer lower prices or higher rebates if their competitors will not know about it, and thus will be unable to match such offers quickly. As noted earlier, the FTC has repeatedly taken the position that greater price transparency would increase—not decrease—actual drug costs.

What Can We Learn From The Commercial Market?

As explained in more detail below, commercial insurers, such as United Healthcare, have recently adopted a policy of subtracting an amount related to the rebate from what the patient must pay at the point of sale. In their business for employer-based coverage and individual coverage, United Healthcare and other insurers have been able to adopt this approach because Medicare’s rules specifying coinsurance as an exact percentage of a drug’s price do not apply. As a result, commercial insurers are able to lower what a beneficiary pays for a drug without automatically revealing either the actual net price or rebate amount, keeping both rebates and negotiated prices secret. This approach is also able to deal with the fact that rebate amounts vary according to an insurer’s or PBM’s performance in steering volume, which will not be known until after drugs are dispensed to patients.

Rebates that rely on actual performance in a subsequent period pose a technical challenge for sharing savings with patients at the point of sale—for both Medicare Part D and commercial plans—because the amount of the rebate is not known at the time a prescription is dispensed. To the extent negotiators want to retain performance-based rebates, pharmaceutical manufacturers and PBMs could invest in sophisticated modeling to project expected rebates based on past data. For example, negotiated agreements could specify the projection methodology, and the resulting estimated rebates could be updated periodically to incorporate the most recent actual data. One might characterize such an approach as establishing a “picture frame” (for example, the specification of an econometric model) along with the timing (for example, quarterly) and process for routinely updating the “picture” in the picture frame; this would allow updating rebate amounts without having to update rebate agreements. Careful modeling combined with extensive data should produce prospective estimates that track reasonably closely to what rebates would have been if computed retroactively based on actual performance.

The Price Transparency Challenge

An array of possible mechanisms would permit commercially insured patients to share in the savings associated with rebates while maintaining the secrecy of negotiations, some of which are in use now. The challenge involves reaching a balance between having patients share proportionately in the difference between a drug’s list and net prices, on the one hand, and not revealing to competitors—whether plans or manufacturers—the negotiated rebate and net price on the other. One option would have insurers base cost sharing on fixed-dollar copayments, not coinsurance. Alternatively, they could apply coinsurance to the average cost of a group of drugs with generally similar net costs.

Another option would have coinsurance percentages for a set of individual drugs vary within a range. Knowing the average price or average coinsurance amount for a group of drugs—but not the actual price or coinsurance percentage for a particular drug—would keep the negotiated terms confidential and prevent “reverse engineering” net prices or rebate amounts. Permitting actual prices and coinsurance percentages for highly rebated drugs to vary from the publicly reported average prices and average coinsurance percentages applicable to a group of drugs would maintain the confidentiality of net prices and negotiated rebates.

As explained above, Medicare’s requirements that coinsurance for prescription drugs equal exactly 25 percent above the deductible and 5 percent above the donut hole currently mean that Part D plans could not apply any of these strategies. However, CMS could potentially use its administrative authority to permit Part D plans to adopt these approaches.

The Premium Increase Challenge

While sharing rebates with patients to lower their out-of-pocket costs would likely cause both commercial insurers and Part D plans to incur higher drug costs, commercial insurers have much more flexibility to avoid having such a policy visibly increase premiums than Part D plans do. This occurs because premiums for commercial insurance differ from Medicare Part D in important ways. Commercial insurance typically bundles drug benefits with overall health coverage, so premium cost associated with drug coverage is not separately identified. National Health Expenditures (NHE) data report drug costs account for 10.8 percent of commercial insurance expenditures; thus, if sharing rebates with patients resulted in an 8 percent increase in average cost associated with drug coverage that would translate to only a 0.9 percent increase in the overall cost of commercial insurance. (Interestingly, the Health Care Cost Institute (HCCI) reports drug spending as 19 percent of commercial insurance cost; while there are other reasons for the difference, the HCCI estimate—unlike NHE data—excludes rebates.)

Additionally, commercial insurance typically has flexibility to modify the important elements of drug and non-drug benefits, the actuarial value of insurance versus cost sharing, and the allocation of premiums between employers and employees. As a result, modest changes in the cost of the drug benefit are unlikely to be visible to commercially insured enrollees—they would be rather small relative to overall cost of health insurance and could be easily offset by other modest changes in benefits or financing.

These changes are more noticeable in Part D. To the extent plans pass through the amount, an 8 percent increase in Part D drug costs would increase the average beneficiary-paid portion of the Part D premium by around $2.62, from $32.74 to $35.36.

Stand-alone Part D plans do not have this flexibility available to commercial insurers. The Medicare statute explicitly created a new, stand-alone outpatient prescription drug benefit with a separate beneficiary premium. Current law precisely specifies the formulas allocating prescription drug costs between the government subsidy and beneficiary premiums, so any increase in plan costs would automatically generate increases in monthly Part D premiums. By placing strict requirements on cost-sharing and benefits, Part D effectively precludes offsetting an increase in plan costs caused by sharing rebates to reduce beneficiary out-of-pocket costs with other changes. CMS annually makes public Part D plan premiums in a widely used website that facilitates comparing current and upcoming year new premiums, as well as comparing the premiums of different plans. As a result, even a modest increase in plan costs fueled by lowering beneficiary cost sharing will generate highly visible increases to Part D premiums.

However, it is worth recognizing that only a minority of Part D enrollees would be directly subject to the full brunt of these changes. Forty-four percent of Part D enrollment is in integrated Medicare Advantage plans with Part D benefits (MA-PD). While MA-PD plans do separately determine Part D premiums according to Part D program rules, most Part D plans use supplemental benefit dollars to offset some or all of beneficiaries’ Part D premiums. As a result, while increases to Part D premiums would reduce funds available for plans to put toward other benefits, modest Part D premium increases would likely be absorbed more readily by these plans relative to stand-alone Part D plans.

Among the 56 percent of beneficiaries enrolled in stand-alone Part D plans, 47 percent of them (26 percent of all Part D enrollees) receive low-income subsidies, so premium increases would be borne primarily by the federal government rather than the beneficiary. Additionally, 18 percent of stand-alone Part D enrollees (10 percent of all Part D enrollees) are enrolled in employer-sponsored stand-alone Part D plans, where employers often subsidize premiums. Indeed, only 20 percent of all Part D enrollees are enrolled in stand-alone Part D without LIS or an employer sponsorship. Thus, potential premium increases associated with sharing rebates at the point of sale would only be absorbed directly by a minority of Part D beneficiaries, although they could result in increased other expenses.

Summing Up: Solutions For Medicare Part D

Sharing rebates with patients poses two substantially greater challenges in Medicare Part D than in commercial insurance: how to share rebates without undermining competition, and the political pushback from having monthly premiums increase. A third issue, sharing performance-based rebates at the point of sale, poses similar technical problems for commercial insurance and Part D but is solvable, as commercial insurers have already done, by basing payments on prospective estimates rather than actual amounts of rebates.

Maintaining the confidentiality of net prices and rebates when sharing rebates with patients could be done either by administratively modifying Part D rules or by legislating reforms. Modified rules could permit using averages to approximate actual prices and actual coinsurance percentages, along the lines discussed above. Giving Part D insurers flexibility to approximate coinsurance amounts would avoid revealing actual point-of-sale prices.

However, Medicare would also need to establish guardrails ensuring that insurers appropriately pass rebates through to patients to reduce cost sharing rather than diverting some of the rebates intended for patients to reducing premiums in hopes of increasing market share. For example, CMS rules might require not only that each insurer must share with patients in the aggregate 25 percent of rebate dollars (and 5 percent in the catastrophic range) but also that rebates be allocated to ensure that the coinsurance paid by patients using particular highly rebated drugs appropriately approximates net prices. In addition to guaranteeing fairness, the rules could prevent preferred risk-selection strategies that would redistribute rebates to drugs used mostly by relatively healthy people.

Beneficiary concerns about increased Part D premiums could be addressed by combining legislation to share rebates with patients with broader legislative reforms to the Part D program. Both the Senate Finance Committee and the Medicare Payment Advisory Commission have advanced Part D reform proposals; these proposals would restructure the Part D benefit design to improve its incentives and alignment with the way the program, and the prescription drug market, have evolved since Part D’s inception. Both proposals would lead to federal spending reductions; a portion of savings could be devoted to offsetting the premium increase that would result from sharing rebates with beneficiaries.

The Initiative is a partnership between the Economic Studies program at Brookings and the USC Schaeffer Center for Health Policy & Economics, and 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.

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