No Good Deed Goes Unpunished

President Biden signed the Inflation Reduction Act of 2022 (IRA) into law on August 16. This bill included several provisions intended to curtail rising prescription drug prices, which have increased in excess of inflation for many years.

Source: Forbes.

Going forward, the IRA will require the U.S. Secretary of Health and Human Services (HHS) to negotiate how much Medicare agrees to pay for the most expensive drugs in the U.S., as measured by total annual dollar cost. This measure will be phased in over time. The HHS will start with the 10 most expensive drugs in 2026, then the 15 next most expensive the following year, and so on. By 2031 the top 100 most expensive drugs will be subject to negotiation.

Timeline and Eligibility Criteria for Medicare Drug Price Negotiation

Source: IRA and L.E.K. Consulting.

Theoretically, this measure should help reign in drug price increases. This is quite topical for an inflation-reduction bill. However, the IRA will also influence what research the pharma industry chooses to pursue. Some life-saving innovations will be de-prioritized due to insufficient profit potential under the new rules.

Drug Pricing Before the IRA

The federal government is the single largest purchaser of prescription drugs in the United States. Yet, before the IRA the U.S. government was not allowed to negotiate the prices of prescription drugs. Instead, prices were negotiated between drug manufacturers and other buyers; the federal government tagged along. This is due to the so-called 'non-interference' clause included in the law that established Medicare Part D and reimbursement rules for Medicare Part B.

The Good News: Drug Costs are Concentrated

U.S. federal government prescription drug costs are highly concentrated. As of 2019, 60% of Medicare Part D drug spend came from 7% of covered drugs, and 80% of Medicare Part B drug spend came from 8.5% of covered drugs. Since the IRA requires the HHS to negotiate prices starting with prescription drugs that cost the most in aggregate, it would seem that the new rules will focus on where they will have the most impact: a relatively small number of costly drugs. Notably, certain prescription drugs are excluded from this framework, such as those that have achieved orphan drug designation (targeting rare diseases) or those that already have a generic or biosimilar competitor in the marketplace.

The Not-So-Good News: Changed Incentives

The net societal benefit from the IRA's drug pricing framework gets a bit trickier to estimate once you factor in the consequences for future drug development. For example, under the new rules the HHS Secretary is required to negotiate prices for small molecule drugs 9 years after FDA approval, and for biologics 13 years after FDA approval. Up until now, prescription drugs enjoyed an average of 14.4 to 21.5 years of market exclusivity for small molecule and biologics respectively. Generic competitors then enter the market and rapidly erode the profitability of the original drug manufacturer. Thus, the number of years a pharma company gets to earn sizeable profits on a successful drug is now significantly reduced. This is the period of time that allows a drug manufacturer to (a) recoup the cost of developing that drug, (b) offset the cost of all the other drugs that failed along the way, and (c) reward its shareholders.

Small Molecules Versus Biologics

What is the difference between small molecules and biologics? Broadly speaking, small molecule drugs are chemical compounds that use biochemical processes to prevent or treat disease. They are the old-school pill you take to address a given medical condition. Biologics, by contrast, are more complex therapeutics that are derived from living sources such as blood, viruses, or the DNA of living organisms. They are harder to research, manufacture, and preserve during storage or transportation. It would seem that the IRA may have sought to preserve incentives for leading-edge biologic drugs while cutting into the profitability of more traditional (and currently more common) small-molecule drugs. Yet, biologicals are not inherently superior to small molecules. Going forward, the pharma industry will be greatly disincentivized from researching new small-molecule drugs even when said drugs would carry significant life-saving benefits. Nine years of market exclusivity may not be enough to justify the investment.

Diseases of Aging

Medicare is a federal health insurance program primarily intended for individuals aged 65 and older. Therefore, the federal government is far more likely to be a large purchaser of prescription drugs that address diseases of aging. Going forward, fewer R&D dollars will go towards developing prescription drugs for Alzheimer's, heart disease, cancer, and other important medical conditions that disproportionally impact older patients.

Life-Cycle Management

The pharma industry makes use of so-called Life-Cycle Management (LCM) programs to maximize profits. Drug manufacturers extend the period of patent protection for a given drug by introducing novel formulations (e.g. extended-release versions) or running follow-on clinical trials. FDA approval for additional indications creates new profit opportunities. Sometimes these incremental indications are highly adjacent, such as a cancer drug that is first approved for terminally-ill patients and later expanded into earlier lines of therapy. Novel formulations and incremental indications will be far less profitable under the IRA, as they will likely fail to reset the market exclusivity clock. In one study, L.E.K. Consulting estimated that the cumulative revenue from a follow-on indication would be 40% lower under the IRA rules. Abusive patent extensions will rightfully be curtailed. But legitimate additional indications will also be mothballed due to insufficient profit potential.

Wag the Dog

While prescription drug prices garner media attention reminiscent of gas prices at the pump ($7.0 a gallon!), they are hardly the reason why Americans currently overpay for underwhelming healthcare. In fact, prescription drugs are only a small part of that problem. The broader dysfunctionality of the U.S. healthcare system is perhaps best attributed to a multi-layered insurance and payment system that adds complexity, bureaucratic cost, and opaque pricing ripe for abuse.