“As any economist will tell you, when you give away healthcare for free, costs tend to accelerate faster than you would like,” says William S. Smith, Ph.D., visiting fellow in life sciences at Pioneer Institute. Smith believes that a combination of the market and good prescription drug policy can increase the affordability of prescription drugs.

The market’s strength is that it incentivizes high levels of innovation – new drug therapies to treat cancer, hemophilia and COVID-19, for instance – followed by generic versions of those drugs that dramatically reduce their cost for the patient. Over the next five years alone, it is estimated that savings to American patients from market-driven development of generic drugs will be over $90 billion.

However, cost-saving measures from some prescription drug market players and failures in prescription drug policy often make prescriptions costlier for patients than they need to be. “The biggest shortcomings I see in the current market is the use of the rebate system in pricing drugs,” says Smith. Subsequently, the drug price used to calculate a patient’s price at the pharmacy window is 48% more than the negotiated/rebated price insurer’s pay.

“The real affordability crisis that state policymakers need to address is out-of-pocket costs,” Smith says. “This is an entirely manageable problem to solve.” Learn more about Smith’s ideas for addressing prescription drug costs by reading Sutherland Institute’s full interview with him below.

Derek Monson, Sutherland Institute vice president of policy: What do you see as the strengths and the shortcomings of the U.S. prescription drug market system?

Smith: The clear strength of the current system is the unbelievable level of innovation that is happening. The amazing work on COVID vaccines and therapies demonstrates that the biopharmaceutical industry is one of the most important economic sectors in the Western world and in the U.S. in particular. Within a decade, we may see gene therapies that can cure some of the most dreaded diseases, not simply in oncology but for conditions such as hemophilia and sickle cell disease. The innovation has been particularly strong in orphan and rare diseases where our progress in mapping the human genome has opened up a world of potential cures for diseases with genetic origins.

The biggest shortcomings I see in the current market is the use of the rebate system in pricing drugs. Many drug companies sign contracts with payers that offer rebates in return for market share, so if insurance company X agrees to push drug maker Y’s therapy, the insurance company can be rewarded with discounts that come in the form of rebate payments. Drug companies are now paying billions in rebates and one study indicates that rebates now make up 48% of the list price of drugs. In short, the “sticker” price for drugs is now 48% higher than the actual price paid by payers. This creates all manner of distortions in the market.

Monson: Which particular trends, developments or parts of the prescription market are helping make prescriptions more affordable for patients, and which are making prescriptions less affordable for patients?

Smith: Let me start with the second question first. The rebate system that I describe above is leading to less affordability for prescription drugs. Coinsurance and copayment requirements have been growing for patients. And, when they are using their own money, many patients pay the “sticker” price, not their insurance company’s discounted price. So, we are seeing out-of-pocket costs skyrocket for many patients.

In reaction to this increase in out-of-pocket costs, many drug manufacturers are offering coupons to patients that make drugs more affordable. Many insurance companies do not like these coupons since they make it more difficult to steer patients to their approved formulary drugs. However, given the growth in copays and coinsurance, it is difficult for me to object to the use of coupons; this is a way that patients can fight back against a rebate system that disadvantages them and over which they have no control.

Monson: You have researched and written about the Institute for Clinical Research and Evaluation (ICER). What should state and federal policymakers understand about this organization and what it is doing in the prescription drug market?

Smith: ICER is a replica of the cost-effectiveness institutes that are attached to the socialized medicine systems in Europe. As any economist will tell you, when you give away healthcare for free, costs tend to accelerate faster than you would like. Therefore, these European health systems put these “cost effectiveness” methods in place to put a fig leaf over the inevitable rationing that must take place to control costs. ICER is very similar to the cost-effectiveness center used by the National Health Service in Britain.

While there is much debate over the model used by ICER, I personally do not take it all that seriously. ICER structures the inputs for their model in order to arrive at a preconceived conclusion: Drugs are too expensive. ICER could change the inputs for their model and it would conclude that all drugs are a bargain, but they don’t want that conclusion. So, there is an arbitrariness to the whole ICER exercise. ICER, to be blunt, stacks the deck.

Monson: You’ve worked at both the federal and state levels on prescription drug policy. Do we have the proper balance right now in federal vs. state administration and jurisdiction over prescription drugs? If not, how specifically does that balance need to change in your view?

Smith: Basically, the federal government subsidizes the prescription drug costs for senior citizens in Medicare, and the states (along with federal matching funds) subsidize the prescription drug costs of lower income people in Medicaid. The Medicare prescription drug benefit has been largely a success since it is delivered by private sector companies who must compete on costs and quality. That is precisely the incentive structure that you want: competition on both cost and quality. So, if one of the Medicare plans offers a low quality formulary where no good drugs are available or if they charge too much, seniors will vote with their feet.

The state-run Medicaid programs do not have the healthiest incentive structure. Because the feds match state spending, there is an incentive to spend more money. If the federal government, for example, told you that it would pay for half of your automobile costs, people would likely have more cars. So we should not be surprised that Medicaid spending has exploded, both due to the federal match and to enrollment growth.

On the Medicaid pharmaceutical program, I am actually sympathetic to the concerns of state Medicaid directors. As I mentioned, there has been an explosion of rare disease and orphan drugs, and a disproportionate number of these patients enroll in Medicaid because they may be living with a disability caused by their rare disease. This means that Medicaid pharmacy spending has been growing at a greater rate than private commercial plans. The federal government needs to take this into account. If I were the HHS Secretary, I might look at ways to reduce the federal match for certain parts of the Medicaid program, and to potentially increase the matching rate for orphan drugs. The approvals of orphan drugs by the federal FDA are, after all, driving up state Medicaid costs.  A more generous match for rare disease drugs would also incentivize research in these therapies for serious diseases.

Monson: In your view, what state policy reforms are needed to improve affordability and access to prescription drugs in the U.S.?

Smith: The crisis in affordability and access to prescription drugs is not driven by higher and higher costs. Many brand name drugs are going off patent, saving the systems billions of dollars when they go generic. One estimate says pharmacy savings in the U.S. over the next five years will be over $90 billion due to generic drugs.

Therefore, the real affordability crisis that state policy makers need to address is out-of-pocket costs.  So, if you are a patient with a 20 percent coinsurance requirement, and you require a cancer drug that costs $100,000, you will be paying $20,000 out of pocket. Patients sign up for health insurance precisely to avoid this type of catastrophic expense and, with overall drug costs not growing, this seems to be poor policy. Moreover, since a small percentage of patients find themselves with this double hit of high coinsurance and expensive prescriptions, this is an entirely manageable problem to solve.

Commercial health plans are private sector entities, so I would not recommend government-imposed mandates to lower coinsurance or copayments. However, many consumers, and the businesses that provide health insurance to their employees, may not be aware of the sometimes crushing coinsurance requirements of some plans. Legislators may consider requiring that their state Department of Consumer Affairs develop an “out-of-pocket scorecard” where patients can learn about their potential out-of-pocket liabilities for the various plans in their state. This may also help employers select health plans for their employees that may take into account the particular health needs of their cohort of employees. Markets operate more efficiently with knowledge, and knowledge of out-of-pocket expenses is an important data point in health insurance markets.