The Real Reason Drugs Cost So Much — and Do Too Little

Until 2003, Medicare covered most hospital and doctor visits for the elderly, but it did not cover the ever-growing costs of prescription medications. Former President George W. Bush changed that when he signed a law adding prescription drug coverage to Medicare.

But there was a catch.

At drug companies’ behest, the Republican-controlled Congress banned Medicare from using its market power to drive down drug prices. The prohibition was controversial at the time — Nancy Pelosi, then the House Minority Leader, called it “unconscionable.” Critics saw the prohibition as the government’s abandonment of the single most effective tool for restraining drug costs.

In the years since, the prices for brand-name prescription drugs have skyrocketed, and the prohibition on negotiation has become even more controversial. Higher prices mean larger co-payments for drugs for some seniors, many of whom live on fixed incomes. It’s also a major budgetary problem: From 2018 to 2021, Medicare spending on the 10 top-selling drugs jumped from $22 billion to $48 billion, far outpacing the program’s overall cost growth over the same period.

That’s why, in last year’s Inflation Reduction Act, President Joe Biden and congressional Democrats partly undid the prohibition. Under the law, Medicare will pay a much-reduced price for drugs that consume a disproportionate share of Medicare spending, ultimately saving an estimated $100 billion over the next ten years. This week, the White House is expected to release a list of the first 10 drugs whose prices will be negotiated under the law.

This reform is already under threat. Concerned about lost revenues and about the possible effects on innovation, the pharmaceutical industry has launched a long shot litigation blitz against the new law. In six cases brought in courts around the country, drug companies say that the law violates the U.S. Constitution in a dizzying number of ways.

The lawsuits aren’t likely to succeed — more on that in a moment — and the effects on the research and development of new drugs, though uncertain, probably won’t be as serious as the drug companies claim. In a way, however, that’s a shame. The drug companies are right that the kind of innovation we get is closely linked to how we pay for drugs.

Although the Inflation Reduction Act marks the most substantial change in how we pay for drugs in two decades, it doesn’t change the fact that drug companies will still be rewarded for bringing a drug to market and selling as much of it as they can — whether or not the drug works very well.

Medicare could pave the way toward smarter drug development by paying more for more effective drugs and less for drugs that are less effective. That would send the right signals about where drug companies should target their research investments. The Inflation Reduction Act isn’t that law. We’ll spend less on prescription drugs because of it, and that’s all to the good, but we won’t be spending any smarter.

In building their lawsuits, the companies have emphasized the nuts and bolts of how the new price negotiation system will work.

Each year, the Centers for Medicare and Medicaid Administration (CMS) will compile a list of all the drugs on which Medicare has spent the most over the prior year. From that list, it will choose a certain number of drugs — starting with 10 this year, eventually rising to 20 per year — that will be subject to negotiation. Some categories of drugs are excluded from price negotiation, including drugs that have not already been on the market for an extended period.

Once a drug is selected, CMS and the drug’s manufacturer will sign an agreement to negotiate. Taking into account a wide range of factors, including the costs of researching and developing the drug, CMS will then offer a “maximum fair price.” (A manufacturer that declines to negotiate will be subject to a hefty excise tax on the drug’s nationwide sales.)

The manufacturer can make a counteroffer to the “maximum fair price” and the agency can adjust its offer in response. But at the end of the negotiation period, the manufacturer will be left with a choice. It can either agree to accept a reduced price for its drug — or it can withdraw from Medicare and Medicaid altogether. The first price cuts are due to take effect in 2026.

The pharmaceutical industry thinks that this scheme is a charade. Facing a ruinous excise tax, drug companies say that they have no choice but to “negotiate” with CMS. Likewise, they’ll have to accept a cut-rate price because no company can possibly afford to withdraw from Medicare and Medicaid, which together account for 45 percent of the nation’s annual spending on prescription drugs. This isn’t a true negotiation; instead, as pharmaceutical company Merck argues, it’s “tantamount to extortion.”

Why does that violate the Constitution? The drug companies advance different theories. Some say that it violates the First Amendment: Drug companies are forced to say that they “agree” that a reduced price for their drug is “fair,” even though the companies don’t think it is. Some say it “takes” their property from them — both the intellectual property in their drugs and the manufactured products themselves — without just compensation in violation of the Fifth Amendment.

Others claim that the large excise tax for declining to participate in negotiations violates the Eighth Amendment’s Excessive Fines Clause. Still others say that the scheme as a whole violates manufacturers’ due process rights because it doesn’t give them enough opportunities to challenge CMS’ decision making. And so on.

Impressive as these claims may sound, none are persuasive — and for the same reason. Medicare is a voluntary program and, like all such programs, imposes certain rules on those who participate. Those rules are called “conditions of participation.” The IRA just creates a new condition of participation for drug companies: either they can agree to reduced prices for select drugs or they can leave the program.

Because drug companies can freely choose whether to waive their rights as a condition of participating in Medicare and Medicaid, the law doesn’t violate the Constitution. (Although the Medicare statute typically imposes a waiting period on withdrawal, the Biden administration recently clarified that companies are free to exit immediately if they do not wish to negotiate.)

It may not be financially realistic for drug manufacturers to withdraw — but that’s not because Medicare and Medicaid compel manufacturers to participate. It’s because the programs are so lucrative to the pharmaceutical industry. (By way of analogy, imagine if Elon Musk offered you a billion dollars to fight him in a cage match. You might be foolish to reject that offer, but that doesn’t make it coercive.)

Indeed, by the drug manufacturers’ logic, the more lavishly a government program spends, and the harder it would be for participants to walk away, the more “coercive” it would be for Congress to cut that very program. That’s absurd.

This isn’t the first time the courts have heard the argument that cuts to Medicare violate the Constitution. But those claims haven’t succeeded. Legal doctrine reflects the common sense distinction between financial inducement and genuine coercion.

Back in 1972, Congress adopted a law that, like the IRA, attempted to rein in runaway Medicare spending. The law created Physician Standards Review Organizations that were given the authority to reject Medicare claims. Incensed, physicians argued that the law violated their constitutional rights to practice medicine as they saw fit.

The three-judge court that heard their claim was having none of it. If the doctors didn’t like Medicare’s rules, they could stop participating in Medicare. “It is true that there will exist economic incentive or inducement to participate in [Medicare],” the court wrote. “However, such inducement is not tantamount to coercion or duress.”

The Supreme Court affirmed that decision without even bothering with a written opinion. And in the years since, the courts haveconsistentlyheld that “where a service provider voluntarily participates in a price-regulated program or activity, there is no legal compulsion to provide service.”

Which means that drug manufacturers will need to convince the courts not to apply existing law, but to change it. In particular, they’ll have to persuade conservative justices on the Supreme Court to build on the decision in National Federation of Independent Business v. Sebelius, the first major case involving the Affordable Care Act.

There, seven justices held that the law’s mandatory Medicaid expansion was unconstitutionally coercive. Why? Because a state that declined to expand would lose all of its existing Medicaid funding, not just miss out on the new money available under the ACA. That penalty put too much pressure on the states and forced them to knuckle under Congress’s demands. The drug manufacturers say that the IRA puts them in much the same position: Unless they accept a low price for one drug, Medicare and Medicaid and will no longer buy any of their drugs.

The problem for drug companies — and it’s a big problem — is that they aren’t states. In NFIB v. Sebelius, the Supreme Court was concerned with ensuring that the federal government didn’t co-opt the states, which are separate sovereigns: “When pressure turns into compulsion, the legislation runs contrary to our system of federalism.” That federalism concern is completely absent here.

These six lawsuits are thus unlikely to have a bright future. That said, they can’t be written off altogether. In recent years, some conservative judges have grown increasingly aggressive in pushing back on Biden administration priorities, especially when it comes to health care. They have issued rulings invalidating the entire ACA, undoing the Food and Drug Administration’s approval of mifepristone, and striking down a requirement for insurers to cover zero-dollar coverage for preventive services.

The pharmaceutical industry’s lawsuits may not hold similar ideological appeal — drug negotiation is wildly popular among Democrats and Republicans alike — but the litigation is still young. Especially if the drug companies notch some early victories, momentum could build for legal arguments that seem far-fetched today.

The likeliest endgame, though, is that the lawsuits will be dismissed, the IRA will take effect, and drug companies will earn billions less than they otherwise would have.

The manufacturers will tell you that this will hurt innovation. The concern can’t be dismissed out of hand. Drug development is expensive: Estimates vary, but it probably costs, on average, somewherebetween $1.3 and $2.9 billion to develop a new drug. Manufacturers make these enormous investments because of the possibility of future earnings, including from billing Medicare. As a result, a reduction in what they can hope to earn from Medicare may mean that some investments into promising drug candidates, especially for drugs meant for the elderly, may not be worth making.

Still, the magnitude of the effect is likely to be small. The private market and Medicaid spend billions on pharmaceuticals every year, and Medicare will still pay a lot for drugs, just a little less than before. There’s also the enormous global market. As a result, the Congressional Budget Office estimates that we’ll have just six fewer drugs coming on the market over the next 20 years than we would have otherwise. That’s a real effect, but a modest one.

The IRA is most notable, in fact, for how little it changes how we pay for drugs. Both before and after the IRA, a company whose drug wins approval from the Food and Drug Administration will usually hold a temporary monopoly, via patents and other forms of market exclusivity, on sales of that drug. During that monopoly period, manufacturers can often demand eye-watering prices for their drugs, including from Medicare.

That’s because doctors usually don’t think too hard about how much a drug costs (if they even know), especially for insured patients. If a particular drug is somewhat more effective than existing alternatives, or has a slightly safer risk profile, that’s what doctors will choose. Physicians’ familiarity with branded drugs, their own financial incentives, and extensive marketing campaigns also favor brand-name drugs.

Insurers push back in various ways, most frequently by requiring physicians to show that patients have tried alternatives and really need the drug. But insurers, especially public insurers like Medicare and Medicaid, do less pushing back than is commonly appreciated. Expensive brand-name drugs are prescribed all the time.

That’s not necessarily a problem. Some drugs are (literally) worth their weight in gold. Think of Sovaldi and Harvoni, which were approved a decade ago and can cure Hepatitis C, a deadly viral disease that once afflicted between 3 and 5 million Americans. Paying a lot for cures encourages drug companies to invest in developing drugs with curative potential.

But most drugs aren’t cures. Drug companies generally earn more, in fact, on drugs that patients take over an extended period. That helps explain why fully one quarter of all drug approvals are for cancer drugs. They’re really profitable, even though they often don’t work very well. The President’s Cancer Panel, for example, has concluded that “many new [cancer] drugs do not provide benefits commensurate with their prices,” a conclusion amply backedupbyresearch. You see the same pattern in drugs for other conditions, including recently approved Alzheimer’s therapies. They’re priced well out of proportion to the health benefits they’re expected to yield.

Drug companies aren’t evil. They’re profit-making enterprises that pay close attention to economic incentives. They aren’t necessarily paid more for drugs that are more valuable for human health; they’re paid, instead, for drugs that sell. And because marginally effective drugs can be sold for exorbitant amounts, a lot of research dollars are plowed into drug candidates that aren’t that valuable.

By the same token, too little is invested in potentially valuable drugs with limited sales potential. There’s a desperate need for new antibiotics, for example, to serve as a last line of defense to “superbugs.” According to the Centers for Disease Control and Prevention, antimicrobial resistance kills an estimated 35,000 people in the United States every year. And the problem is getting worse as bacteria evolve and develop resistance to more and more classes of antibiotics.

But we’re not filling the antibiotic pipeline. A big reason why is that preserving the efficacy of new antibiotics would require limiting their use to when they were truly needed. Fewer pills mean fewer sales, however, which is why nearly all large drug companies have left the market. A similar story accounts for the relative dearth of investment into neglected tropical diseases that afflict millions worldwide.

How we pay for drugs, in short, sends the wrong signals to the market about the kind of innovation we value. The good news is we can fix that. As law professor Rachel Sachs has argued, Medicare and Medicaid (and to some extent private insurers as well) are required by law to cover all FDA-approved drugs, whatever their value to human health. That linkage can be severed. We could give CMS the authority not only to drive down the prices of the most expensive drugs, as the IRA does, but also give it the power to pay less for, or even exclude coverage for, drugs of marginal efficacy.

Connecting payment to value would be complicated, and there’s no perfect way to do it. It would also be controversial: Paying less for some novel therapies would likely restrict access to therapies that some patients desperately want. But we’d send much smarter signals to drug manufacturers about where to target their investment dollars. And the benefits of better-targeted innovation would accumulate over time, vastly improving human health in the long run.

The IRA was meant to save the taxpayers’ money, not to improve their health. That was worth doing. But the next reform to payment policy ought to aim higher.