Instead of Drug Spending Caps, Medicare Should Try Value-Based Contracting

New regulations may require regulators to explore new payment options.

Few issues raise the ire of Americans more than the high cost of prescription drugs–and the Biden administration is seeking to tackle the issue through provisions in the recently passed Inflation Reduction Act. According to advocates, the law offers an effective way to begin the process of curbing high drug prices, thus making medical care more available and reducing costs to society. According to opponents, the new rules will harm innovation, with hundreds of potential treatments and cures left on the table because companies will have no financial incentive to pursue them.

That puts the government, the medical industry, and patients between a rock and a hard place: Cutting costs will save patients and taxpayers money, but could end up harming people who would otherwise have benefitted from still-undeveloped treatments. Is there a way to ensure lower prices while still encouraging innovation? I believe there is–and that solution entails implementation of value-based pricing for drugs, whether for Medicare or private insurers.

As it stands, the new law will institute significant changes, including granting Medicare the power to negotiate prices with pharmaceutical companies for as many as 60 drugs by the end of the decade. In addition, companies that raise drug prices faster than the rate of inflation will be required to pay rebates to Medicare. Finally, out-of-pocket drug costs for many Medicare recipients beginning in 2026 will be capped at $2,000 a year. The cap will mark a dramatic change for those patients, who until now were solely responsible for a co-pay (with no upper limit) for drug costs over $7,050. As a result, patients who require expensive treatments that may have cost tens of thousands of dollars a year will find themselves saving significant amounts of money.

But how will Medicare maintain that cap–paying for all of a patient's treatments above $2000 a year–without going broke? Presumably, it will build that cap into its negotiations with pharmaceutical companies. That’s why some opponents say that these spending caps will act more like price controls And, according to many in the industry, these price caps “masquerading” as price controls will end up harming sick people, especially those with rare and difficult-to-treat diseases, as companies receiving less revenue from drugs cut research on new treatments for conditions that have not yet been addressed. On the other hand, advocates of the spending caps say that pharmaceutical companies make significantly more money than companies in other industries, and can afford to cut prices while maintaining innovation. In addition, they say, the impact on innovation would be a lot less dramatic anyway, as companies seek to develop drugs for patients that are currently not served or underserved.

If past history is a precedent, those who argue that price caps or controls will stymie innovation have a point. Price controls on drugs have been in place in some European countries for decades, and studies show a direct correlation between the implementation of caps and a significant dropoff in pharmaceutical research and development, as well as investments in drug companies. For example, one study shows, biotech investments in the United States between 2003 and 2019 increased sixfold, while they remained static in the European Union. With that, almost everyone–from consumers to industry officials–agree that something must be done about high drug prices.

Value-based drug contracting could be the better “third way.” This means basing the newly-allowed price negotiations on patient value and outcomes—rather than on spending or price caps. Under a value-based pricing model, a drug is priced based on its effectiveness and outcomes–with pharmaceutical makers charging more for drugs with overall positive outcomes, and charging less (or supplying rebates if a drug is paid for in advance) for treatments that do not meet criteria. The more effective a drug, the higher the target price payers submit–with discounts and rebates given for drugs that are less effective than expected. (For full disclosure, my company’s digital analytics platform was developed to create value-based contracts by pharmaceutical companies and payers.)

This model would work well for Medicare, which could set criteria–overall lifetime expenditures for patients receiving a specific treatment, for example–and use it to determine the proper price to be paid. If a treatment reduces the overall cost of lifetime treatment for a patient by 20%, for example, that outcome would be factored into the price Medicare pays for it; if the results were better, that drug would be worth even more money, and its maker would reap a bigger profit.

A value-based pricing system would benefit all parties. Medicare would be paying more for the most effective treatments, and far less for the ones that would not save the agency money over time. Drug makers would be able to reap fair profits from their best offerings, and use that money for R&D while ensuring profitability–and the prospects of further profitability from well-performing drugs would further increase incentives for companies to develop innovative and cost-effective treatments. And of course patients would benefit, as Medicare could maintain its out-of-pocket patient payment cap while working with pharmaceutical companies to ensure fair prices and encourage innovation.

Implementing a system like this would require data on the historical and current performance of drugs–but that data is already largely collected by hospitals and care providers. With the right analysis systems, Medicare – as well as private insurance companies, for that matter – could determine which drugs are worth the price pharmaceutical companies seek, and which prices should be negotiated down. With value-based pricing, everyone leaves the doctor's office a winner.

Girisha Fernando is CEO and founder of Lyfegen.