Towards a better understanding of drug pricing

The prescription drug plan everyone wants is one which involves paying a third party a small monthly amount that then allows you to get all the medications you may need by presenting a nice shiny prescription card to your local pharmacy.

It’s an interesting model to reach for because the model falls apart under even the lightest scrutiny. Think about creating the same program for shoes. The problem with the shoe insurance program becomes immediately obvious — you couldn’t just buy any shoe at the local Nike store by presenting this shoe insurance card. The shoe insurance program would no doubt place restrictions on what shoes you can buy, and how frequently you could buy these shoes. There would no doubt be a preferred list of shoes that were expensive and highly sought after because Justin Bieber was wearing and hawking them on TV .. these shoes would at most only be partly paid for by the shoe plan, if at all. The reasons for these restrictions would be obvious to everyone— the shoe plan would be paying for shoes through premiums paid by subscribers. Any plan that didn’t have an appropriate amount of restrictions on the frequency and price of shoes that could be bought would quickly be insolvent. Who would want this plan?

There is a little difference mechanistically between the hypothetical shoe insurance program outlined and the common prescription drug plan patients buy. No one sees much use for a shoe insurance program. People just go to the shoe store and buy a pair of shoes that fits their budget and tastes.

But healthcare is different from shoes in some really important aspects. You don’t generally die if you don’t get those air jordans, but you are likely to die if you are unable to pay for anti-virals that keep the HIV virus in your body in check.

A wealthy society faced with the possibility of our fellow citizens dying without access to life sustaining medications naturally creates mechanisms to prevent this from happening. There are solutions that would naturally arise in the private sector similar to flood, fire and hazard insurance but all of these solutions put some burden on citizens. You legally have to have car insurance in order to drive. The penalty of not having car insurance and driving isn’t death, though. And again, if you don’t have enough money to buy car insurance, don’t drive a car. Health care poses unique challenges, and unique challenges are where politicians arrive with their beautiful solutions.

The underlying fundamentals may make the solution impossible, but that doesn’t deter politicians who have much to gain by promising unicorns and pots of gold at the end of rainbows to citizens.

And that’s how we get the Medicare Part D prescription drug plan — a great example of a “working” government program that the average American has little to no understanding of, but it does fulfill the basic idea of presenting a prescription card and getting medications in return. Pulling the covers back on what the financing of this program looks like is a clarifying exercise for those more interested in unicorns and leprechauns.

An aside about differing opinions. A variety of individuals may take the exact same set of data and come to different conclusions based on their differing lived experiences, value systems and pre-existing biases (Economists and Statisticians are especially good at doing this), but it is a completely different level of discussion when all parties don’t have a good grasp of the underlying facts. The world is a complicated place, and at times it may even be impossible to know enough about a topic to have an informed opinion without years of fully committed study or years of living and breathing what you want to have an opinion. But at the very least there are basic facts that are worth understanding about a topic.

The history of Medicare part D dates back to 2006 when Republican president George W. Bush pushed through the bill that brought it to life. The basics were as follows:

Medicare part D is an optional prescription drug program that Medicare eligible citizens enroll in through private insurance programs approved by the Medicare program.

Prescription drug plans can be accessed as stand alone plans when enrolled in traditional Medicare or are bundled through the Medicare Advantage programs (otherwise known as Part C)

Enrollment typically occurs during the Initial Enrollment Period (when you turn 65 or become eligible for Medicare) or the Annual Enrollment Period (October 15–December 7), with coverage starting January 1 of the following year. Special Enrollment Periods may apply for certain circumstances, like moving or losing other coverage.

Not unlike our fictional shoe insurance plan each plan has a formulary, a list of covered drugs divided into tiers with different cost-sharing levels (e.g., generics vs. brand-name drugs). Plans are required to cover at least two drugs in each therapeutic category and key drug classes.

Patients pay for these plans in the form of monthly premiums, deductibles and co-insurance but in a massive divergence from the shoe plan, the federal government steps in to create the market through direct payments to prescription plans to make the plans affordable to patients. The breakdown, with some 2025 numbers for reference:

1. Premiums: Monthly payments vary by plan (e.g., $0–$100+ in 2025, depending on the plan and region).

2. Deductible: Some plans have an annual deductible (up to $590 in 2025) before coverage kicks in.

3. Copayments/Coinsurance: You pay a portion of the drug cost (e.g., $10 for generics, 25% for brand-name drugs) based on the plan’s tier structure.

4. Coverage Gap (Donut Hole): In 2025, after total drug costs (what you and the plan pay) reach $5,030, you enter the coverage gap. You pay no more than 25% of the cost for covered drugs until reaching the catastrophic coverage threshold.

5. Catastrophic Coverage: Once your out-of-pocket costs exceed $8,000 in 2025, you pay $0 for covered drugs for the rest of the year.

6. There are added subsidies for those making below certain income thresholds with low-income beneficiaries qualifying for the Extra Help program, which reduces or eliminates premiums, deductibles, and copays. Eligibility depends on income and resources (income below $22,590 for individuals in 2025, with some asset limits).

So far, I have just rehashed what any good broker would tell seniors about the Medicare Part D program.

Less well understood is exactly how heavily the federal government subsidizes Medicare Part D and what spending trajectory has been since its inception.

The largest funding source for Medicare Part D comes not from patients, but from general revenues that are drawn from federal income taxes and other general revenue streams in the US Treasury. You are reading that right, Medicare Part D is largely financed by tax revenues, not patient payments.

Federal subsidies take the form of direct subsidies to plans for each member they enroll, as well as payments to plans for ‘catastrophic claims’. In 2025, general revenues are projected to fund ~$103billion of Part D’s total spending that is estimated at ~$137 billion. The monthly premiums enrollees pay fund the remaining 20-25% of the total cost of the Medicare Part D program. Higher income enrollees pay an Income related monthly adjustment that kicks at incomes above $103,000 (single) or $206,000 (married). States step in as well by contributing to the Part D program for dual-eligible enrollees (Medicare-Medicaid enrollees). These funds help pay the low income subsidy mentioned earlier.

A word about the federal governments plan to cover high cost, ‘catastrophic’ claims. The major mechanism is via federal government reinsurance payments to Part D plans for enrollees with high drug costs. Reinsurance is a relatively common tool used by insurance companies to protect themselves from large catastrophic claims. Private insurance companies normally share risk by purchasing insurance policies from other insurers to limit their own total loss in case of disaster. In this case, Uncle Sam set up a program that made absolutely sure private insurance companies wouldn’t have to deal with large losses/claims. In 2023 and 2024, Medicare paid 80% of the bills for catastrophic coverage, while insurance plans were only on the hook for 15% of the total claim. If it seems like this was a game designed to make sure insurance companies cannot lose, that would be accurate.

Source: Kaiser Family Foundation

These machinations prevent costs being passed on to patients in a significant way that would make the insurance product undesirable, but this also means there is little ability to exert any downward pressure on drug prices. Not surprisingly, the rise in the federal government payouts for catastrophic coverage was meteoric, from $5.8 billion dollars at the inception of Medicare part D, to six times that (~$33 billion) in 2015.

It will be no surprise to anyone reading that American seniors did not observe health care outcomes improve by a factor of 6 in those 10 years.

Faced with completely out of control prescription drug costs that were blowing a hole in the federal budget (and Seniors wallets - 5% of a large number can still be a very big number for most seniors) the Biden administration passed the Inflation Reduction Act to cap the out of pocket payment payments to $2000 to enrollees and reduce Medicare’s portion of the catastrophic coverage bill to 20% of the total instead of 80%. The bulk of the catastrophic payments now had to be covered by the Part D plans.

In response, insurance companies nearly tripled their 2025 bids for insurance premiums that would be paid by enrollees.

Michael Cannon from the Cato Institute described what happened next :

That presented the Biden–Harris administration with a problem. Left to its own devices, federal law—which is to say, Congress—would dramatically increase Part D premiums right before this November’s presidential election. Angry seniors could take out their frustrations on the Democratic nominee, Vice President Kamala Harris.

So the Biden administration struck upon a scheme: spend taxpayer dollars on a sham Medicare “demonstration program” that hides from enrollees the cost of the IRA’s expensive new coverage by shifting that cost to taxpayers. Federal law allows Medicare to create demonstration programs that test new ideas (payment reforms and the like) in small corners of the Medicare program. The Biden–Harris administration (ab)used that authority to create a “demonstration program” that offers all insurers who participate in Part D new, temporary subsidies—if they pledge not to increase premiums before Election Day.

It’s an incredible story that should be front page headlines for all the major news outlets — a presidential campaign forced Medicare to create a one time funding source during an election year as a patch for a bad solution (the IRA) for a non solvent program (Medicare Part D).

You don’t have to have a PhD to understand the solution government officials reach for when a government program created with great fanfare turns out not to be financially solvent — price controls.

Price controls are so very attractive that even some former Austrian econo-philes embrace them as a pragmatic solution to non-working government programs. But again, a cursory analysis reveals the fundamental error of allowing bureaucrats to set prices — a blind monkey throwing darts at a number board has a higher chance of getting the price right.

Take the drug apixaban, one of the most commonly prescribed anticoagulants that Americans have a high demand for because it is part of managing an arrhythmia that develops at a higher rate in overweight individuals with hypertension and sleep Apnea.

In 2021, $12.6 billion was spent on apixaban under Part D. The $12.6 billion represents the total gross cost of Eliquis prescriptions filled under Medicare Part D in 2021, as reported by Medicare data. This is the aggregate amount billed for Eliquis across approximately 3.9 million beneficiaries before accounting for rebates or discounts.

This gross spending includes plan payments to pharmacies for Eliquis (negotiated prices that aren’t public) and beneficiary cost-sharing (copays/coinsurance, e.g., ~$30–$55/month per beneficiary).

Since the price of any good is a function of the amount of the subsidy provided, it is worth estimating the size of the federal govt. subsidy for each Apixaban prescription.

Medicare subsidies come in the form of :

• Direct subsidies: Monthly payments per enrollee (e.g., ~$100–$150/month, varying by plan).

• Reinsurance: Medicare covers 80% of drug costs in the catastrophic phase (e.g., when a beneficiary’s total drug costs exceed ~$7,400 in 2021). For high-cost drugs like Eliquis, many beneficiaries reach this phase, so Medicare’s reinsurance payments are significant.

• Low-income subsidies (Extra Help): Additional funds for eligible beneficiaries to cover copays or premiums.

So $12.6 billion is the total cost of Eliquis prescriptions written for 3.9 million subscribers, but Medicare’s actual contribution per subscriber isn’t $12.6billion / 3.9 million = $269/month.

Medicare’s actual payment are reduced by

1. Beneficiary payments (copays/coinsurance (e.g., ~$40/month, totaling ~$1.9 billion annually for 3.9 million beneficiaries).

2. Rebates : Plans negotiate rebates from manufacturers (e.g., 20%–30%, or ~$2.5–$3.8 billion for Eliquis in 2021), reducing the net cost to plans.

3. Plans using their own funds (from premiums and other sources) to cover part of the cost.

To estimate Medicare’s portion, we take the gross cost / beneficiary ($12.6 billion ÷ 3.9 million = ~$3,230/year or ~$269/month) and subtract beneficiary copays: (~$40/month × 12 × 3.9 million = $1.9 billion) , rebates (25% of $12.6 billion = $3.15 billion). This leaves a net cost to plans of $7.55 billion ($12.6 billion – $1.9 billion (copays) – $3.15 billion (rebates) ).

Since patients on apixaban are typically older with more comorbidities it’s likely Medicare’s subsidies (direct subsidies + reinsurance + low-income subsidies) cover a significant portion (~50-70%) of this $7.55 billion net cost. This works out to around $112/month that the federal govt is paying for every Apixaban prescription. The manufacturer of Apixaban prices the drug with the full knowledge of the subsidy. It all but guarantees a price for Apixaban that is at least 2x the subsidy.

The solution provided by the Biden-Harris Inflation Reduction Act is to set prices by forcing drug manufacturers to negotiate prices with Medicare, and arrived at a price for Apixaban of $231/month. The public relations campaign for the Inflation Reduction Act presents the cost savings in the following chart :

Source: CMS

A “56% price reduction” that is based on the list price of $521 for Apixaban that almost no one who is Medicare eligible was paying before. Look how carefully the CMS chart is labeled to get around that fact : the column headings are Total spent, and discount from list price, but not amount saved. That’s because the total aggregate amount saved is 14% or $38 / month ($269/month vs. $231/month).

The story gets worse.

The assumption is that Apixaban has no substantially equivalent drug. While it is true that Apixaban has no generic equivalent, there are multiple substantially equivalent generic equivalents — Warfarin and Dabigatran. Warfarin is not as convenient and requires weekly finger pricks or blood tests, but costs $5-10 per month. Dabigatran does not cover every indication that apixaban does but for the most commonly prescribed indication (atrial fibrillation) is available for $70-$80 / month.

It is highly likely that if the government had just not blinked and created these massive subsidies for the manufacturer of Apixaban to enjoy, the per unit price of Apixaban would be markedly less than the $231 / month negotiated through the Inflation Reduction Act.

The price setting part of the Inflation Reduction Act is essentially a PR campaign carried out on behalf of Medicare Part D. Subscribe to Medicare Part D to get the “cheap” price! Except it’s all just a giant smoke screen that actually works to keep drug prices high.

The price set for Apixaban is still too high, but this will be used to suck more seniors into a program that is only solvent with increasing federal govt. subsidies or other “one time” funding bandaids.

The superior approach for the country to make drugs more accessible is to simplify the process for acquiring the vast majority of drugs by loosening the grip of third parties on the market. There are certainly segments of the market with lethal / severe rare diseases that may continue to need some type of third party payer support to create a market, but most drugs just don’t need this kind of support. The perversions these incentives create also mean more metoo drugs we don’t really need and a smaller fraction of drug development directed at deadly diseases that don’t have good answers.

To summarize:

1. The involvement of third parties and the government in assisting citizens with getting the drugs they need is responsible for raising the cost of the drugs.

2. Insurance Premiums for the Medicare prescription drug plan are kept low by large federal subsidies that have until recently helped to cap the cost of very high cost drugs.

3. The federal government is not very good at setting a “good” price for drugs, and in the case of Apixaban set the price too high.

4. Make sure you ask your doctor for generic alternatives or substantially equivalent generics!