Medicare Drug Price Negotiations: Harmful Side Effects?

Prices for select drugs covered by Medicare will be subject to negotiations in the coming years under the Inflation Reduction Act of 2022 (IRA). The goal is to bring much-needed relief to seniors who must sometimes choose between buying expensive medications and putting food on the table. As investors, we analyze legislative developments like the IRA from many angles to understand the risks and opportunities they present.

Potential Impact of Drug Pricing Reform on the Pharma and Biotech Industries

The IRA will likely have little impact on consumers beyond slowing the rate of price increases for Medicare prescriptions over the next few years. Of course, that could mean a great deal to some individuals.

The IRA almost immediately limits price increases to the rate of inflation, and drug companies must rebate any increases beyond that amount to the government. The effect on drug manufacturers’ profit margins will not necessarily be negative, as the Consumer Price Index (CPI) used to determine the inflation rate could be higher than increases in a company’s actual expenses.

Longer-term impacts could be far more significant. Pharmaceutical companies could see declining revenue from drugs whose prices are subject to negotiations, and the entire U.S. drug industry could change due to incentives created by the IRA.

Drugs Most Likely Impacted by Pricing Reforms

According to the Kaiser Family Foundation, spending on prescription drugs covered under Medicare Part D (drugs sold by retail pharmacies) and Part B (administered by physicians) is highly concentrated among a small percentage of all drugs prescribed, mainly those without generic or biosimilar competitors.

Therefore, prime candidates for price negotiations are likely to be brand-name and biologic drugs without generic or biosimilar equivalents. The drugs selected will be:

• Covered under Medicare Part D or Part B.

• Among the highest-spending Medicare-covered drugs.

• At least nine (small molecule drugs) years and 13 years (biologics) after Food and Drug Administration (FDA) approval (depending on the type of drug).

The initial group to undergo price negotiations will include 10 high-cost drugs covered under Medicare Part D. Since negotiations won’t take place until 2026, the earliest a pharmaceutical company would see a lower price on a drug sold to Medicare recipients is 2027.

Most drugs that are today’s biggest revenue generators are in the latter part of their product life cycles, which helps explain why pharma stocks did not react sharply when the IRA passed. For example, Merck’s Keytruda^®, projected to be the world's best-selling prescription drug next year¹, will be on the brink of U.S. patent expiry in 2027. Pfizer’s Ibrance^®, a mega-blockbuster drug used to treat breast cancer patients (many of whom are on Medicare), goes off-patent in 2026.

Long-Term Effects of Medicare Drug Price Negotiations

Despite a relatively small initial impact, the potential long-term effects on the industry could be profound.

Expect to See Higher Prices on New Drugs

Drug price increases in 2020 were higher than the rate of inflation for the vast majority of the 25 drugs that captured most of the spending under Medicare Parts B and D.² While the IRA now prohibits companies from raising Medicare’s drug prices by more than the rate of inflation, it says nothing about initial pricing for new drugs. Setting a high initial price is a long-standing practice in Japan, where drug prices are subject to mandatory biannual reductions after a set number of years.

Today, only a small number of drugs in the U.S. are priced above $500,000 per year per patient, with a handful exceeding $1 million per patient annually. As a result of the IRA, we believe more new drugs will carry these eye-popping price tags. In other words, the industry’s response to the IRA will likely be as follows: “You want to limit price increases and mandate price cuts? No problem. We’ll start at $3 million and negotiate a 20% discount.” What a bargain.

Drug Companies May Prioritize Biologics

In our view, well-intentioned but ill-advised public policies over the last few decades have favored biologics over small molecule drugs, i.e., pills. This is reflected in higher sales growth for biologics compared to conventional drugs. We expect this trend to continue as another unintended consequence of the IRA. Pills are protected from Medicare price negotiations for nine years, compared to 13 years for biologic drugs. This gives companies an incentive to develop biologics rather than pills.

Unfortunately for consumers, biologics are typically more expensive to develop and much more costly to administer. Patients can fill a prescription for pills at a pharmacy and take those pills at home, but biologics are injected, usually at a clinic or hospital.

The newest types of biologics, cell and gene therapies, must be administered in an intensive care unit where a one-night stay could cost tens of thousands of dollars. Even in the best-case scenario where patients self-inject at home, there are additional costs for injectors (often single use) and refrigeration, which increases distribution costs. These add-ons are not included in drug prices but involve real money.

COVID Treatments: A Textbook Example of Biologic vs. Pill

Patients always prefer pills over injections, so drugs in pill form tend to have a greater impact than an equivalent biologic, assuming they are equally effective. Our experience with COVID-19 treatments offers a textbook example.

Covid antibody injections (developed before the Omicron variant appeared) effectively prevented hospitalizations and deaths among high-risk patients. However, the treatment was greatly underutilized because many people could not easily reach a clinic or hospital that could provide the IV infusion required. Then Paxlovid™ pills were developed and widely distributed. Together with vaccines, Paxlovid is one main reason we are now able to co-exist with COVID.

In fairness, up to now, it has been easier to develop a biologic for a specific target than to make an equally efficacious pill. However, we are on the cusp of technological breakthroughs that will allow us to make more effective pills more easily. Using artificial intelligence, companies can now screen billions of candidate molecules and predict those with the best chances of targeting a disease or illness.

Yet, the IRA’s 13 years of protection for biologics compared to nine years for pills complicates the analysis drug manufacturers must make in pursuing new drug development.

• Small molecule (pill) — Takes longer unless new technologies come through and has fewer years of price protection. However, consumers vastly prefer pills to injections, so actual use, and therefore revenue, could make this more profitable even with less price protection.

• Biologic (injection) — Faster to develop and has more years of price protection, but costly to administer. Consumers do not like injections and may skip treatments, reducing revenues relative to what a pill form of the drug would have generated.

This tricky analysis may dissuade some companies from investing additional time and money to create drugs in pill form. As Figure 2 shows, biologics have had a good track record in terms of FDA approvals, so drug companies may continue along this path.

Companies May Delay Launching Drugs Targeting the Medicare-Eligible Population

Under the IRA, a company may have only nine years to recoup its research and development costs and earn a return before it must negotiate a drug’s price. Knowing this, drug makers may postpone a drug’s launch until its near-term uptake is likely to be big — think multi-billion-dollar sales in the first year.

This approach differs from the previously more common strategy of getting new drugs on the market based on what is known as a limited indication of use to keep testing time and related costs in check. After the initial launch, the company seeks to broaden the drug’s indication to more groups using bigger trials.

The drug industry argues that this strategy will no longer make sense because the countdown toward mandatory price negotiations starts the day a drug first obtains FDA approval. The clock starts even if the initial approval is only for limited situations. Industry executives who opposed the legislation say this will delay new drug launches, harming patients.

While this argument has some merit, in our view, the situation is more nuanced. The strategy of “pursue based on a small initial indication” has led companies to produce some mediocre drugs. For example, a drug launched based on its ability to extend life by a few months for patients in the end-stage of a disease may have only limited efficacy in a broader group of patients.

The growth rate in the U.S. drug industry’s research and development pipeline suggests that development times for new drugs have been increasing. These numbers could reflect a boost in the number of drugs in development thanks to new technologies. However, we think a more likely explanation is that companies are running bigger trials to pursue larger initial sales, which keeps drugs in the pipeline longer.

We believe the IRA may motivate companies to take a harder look at their drugs in development. Instead of making fairly small investments to obtain approval based on limited trials, companies will have to decide whether to make significantly larger investments across different trials to determine if there is a large market for a drug. While the prospect of committing much more money does not guarantee better decision-making, we believe it is an incentive to conduct better due diligence and more early-stage trials, which may result in better drugs.

Bigger, Later Launches Threaten Small Biotech Firms

The equity market is not welcoming to pre-commercial stage biotech companies, so their funding sources are limited. Running bigger trials to prove applicability to a large market may be impossible when there is no money to do so. But without bigger trials, small companies will likely have difficulty finding investors or an acquirer precisely because their drug candidates have limited initial markets.

We have already predicted that many biotech companies will likely fail due to the market’s risk-off attitude that has produced a drought in equity funding. The IRA is likely to exacerbate this mass extinction.

U.S. Drug Market May Become Less Attractive

Although Figure 3 shows that the U.S. leads the world in developing new biologic drugs, the approval process has been challenging. As a result, some new drugs can be stuck in the pipeline for years. For example, the Prescription Drug User Fee Act (PDUFA) allows the FDA to collect fees from drug companies to help cover the cost of reviewing regulatory filings. However, the FDA regularly misses deadlines for the decision dates required under the PDUFA.

The regulatory approval process is less painful in other parts of the world. The European Union frequently makes new drugs available sooner than the U.S. Furthermore, Canada is typically faster, and China is quickening its drug approvals. The Middle East, particularly the UAE and Israel, often leads the way in approving important drugs. The IRA may first lead drug makers to pursue commercialization outside the U.S., especially for drugs with limited initial indications.

Potential Boom in Medical Tourism

Wealthy patients will go wherever the best medicine is available. Today, people from all over the world come to the U.S. to seek care. Other destinations include Dubai, Shanghai and Singapore, which are known for specific expertise — for example, transplants and cell therapy in China. An added reason might be to obtain cutting-edge medicines that are not available in the U.S.

Can We Control Costs and Develop Effective New Drugs?

At American Century Investments, we have a strong connection to medical research. Our largest shareholder, the Stowers Institute for Medical Research, funds and conducts foundational biomedical research to help develop innovative approaches to diagnose, treat and prevent disease.

We believe drug companies play an essential role in developing medicines that improve and save lives. We also believe shareholders must be fairly compensated for supporting those efforts and that prices on drugs that millions of Medicare-eligible consumers need should be reasonable. We believe this is a thorny problem and that the IRA may create incentives that conflict with these goals. We will continue to monitor how drug companies and their shareholders respond.