While drug makers have discretion over how to price their products, they are clearly responsive to the incentives they face. In a new paper, we study whether the incentives from one major public program—Medicare Part D—have contributed to higher list prices of branded drugs over time.

One of the most notable recent trends in drug markets is the divergence of list and net prices of branded drugs. While all drugs have manufacturer-reported list prices that tend to increase with time, insurers typically buy branded products at much lower “net prices” that reflect statutory discounts (e.g., in Medicaid) or negotiations (e.g., in private markets or Medicare). Patients, however, often owe cost sharing that is a function of the full list price.

This phenomenon has attracted significant policy attention and likely reflects a host of factors. Pharmacy Benefit Managers, for example, are paid in a way that incentivizes them to prefer drugs with a high list relative to net prices. Insurers may also benefit because this pricing strategy can moderate premium growth by increasing costs for the relatively few patients taking expensive medications. This gives drug makers a reason to set high list prices and offer large rebates.

Beyond these market-wide explanations, experts have argued that the design of Medicare’s prescription drug benefit, Part D, may incentivize insurers to favor drugs with high list prices and large rebates. In short, due to the current Part D benefits design, insurers are liable for a small share of costs once spending is high enough. High list prices coupled with high rebates can help move beneficiaries into these portions of the benefit (and offload more spending on the federal government). Those incentives grew following policy changes in 2011 and 2018.

In a newly released paper in Health Services Research, we empirically test this theory. If Medicare Part D includes a particularly strong incentive for drugs to have high list prices and high rebates, then this phenomenon should be more pronounced for drugs that predominantly target the Medicare market.

To test this, we compared two key metrics for each brand drug in our sample: (1) the fraction of patients taking the drug who are on Medicare, and (2) the ratio of the net and list price of the drug. The former measures how important the Medicare market is to a drug while the latter captures the difference between list and net prices.

To summarize the main result, the figure below shows the relationship between these variables in 2010, when the incentive was weaker, and in 2019, when the incentive was stronger. The size of each data point reflects the net sales of each product.

Over time, the net-to-list price ratio of branded drugs fell in general, indicating a larger difference between net and list prices. However, this was much more pronounced for drugs with large Medicare market shares. We found similar results when using a quasi-experimental approach. This result is consistent with the theory that Medicare Part D encourages higher list prices of brand drugs coupled with large rebates.

Importantly, however, these data clearly suggest that other factors matter. Among drugs with similar Medicare market share, we still observe large variation in pricing strategies, even in 2019. This suggests that other incentives, like those mentioned above, affect the way that drug makers set prices.

Figure: Comparing Medicare Market Shares and Net-to-List Price Ratios of Brand Drugs, Select Years

Looking forward, we expect these incentives to abate as the Inflation Reduction Act (IRA) drug pricing provisions are implemented. Beginning in 2025, the design of Part D will change to give insurers much stronger incentives to manage high-spending enrollees and lower the incentive to prefer drugs with relatively high list prices. Future research can examine whether the patterns we observe change as a result.

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