(This column is part two in a two-part series. Part one, “Average drug prices need a real fix,”discusses the inflation of average wholesale prices of drugs and the resulting windfall some doctors experience.)
Avoiding the creation of moral hazard — a perverse incentive that motivates people to do things that are bad for society — is a never-ending challenge for insurance companies and policy makers.
Recently, that challenge has resulted in a lawsuit filed by Minnesota Attorney General Mike Hatch, who alleges that a drug maker exaggerated the spread between what it pays for drugs and what it lists as the average wholesale price.
Moral hazard is inefficient: It wastes resources by using too many of them or by motivating the use of resources in ways where the value they produce for society is lessened.
Insurance companies have faced moral hazard since the industry began more than 500 years ago, and they have developed some simple but effective measures to combat it.
Life insurance policies typically include clauses that exclude payment in case of suicide or establish a period of one or two years that must lapse between the date the policy is taken out and when death by suicide is covered. That reduces the incentive for depressed or desperate persons to buy policies and immediately kill themselves so that their dependents get the proceeds.
Similarly, writing deductible amounts into home and auto coverage gives the insured owner of such property a financial incentive to exercise care to prevent minor damage. When insurance companies are liable for the first dollar of any damage and the owner is liable for none, human nature is such that even honest people will be less vigilant in avoiding damage than when there is a deductible.
Avoiding moral hazard is harder in other situations. When private or government health insurance is structured so that health providers are reimbursed more for drugs than the price actually charged by the manufacturers, taxpayers and co-paying patients are forced to spend more than they might have to otherwise.
More important, the doctor’s professional judgment on the best drug or device is distorted by the financial incentive of which manufacturer offers the most lucrative “spread” between the price charged the doctor and the much higher “average wholesale price” on which Medicare and Medicaid reimbursement is based.
Some of my friends who are doctors retort that they are bound by their professional ethics and the Hippocratic oath and that monetary considerations would never enter into a decision on which drug to use. Sure — and political contributions don’t influence votes in Congress, either, because lawmakers are sworn into office with an oath requiring them to serve the public and the Constitution! Human nature is human nature, and experience shows that physicians are not more or less honest than the general population.
Other doctors may respond that their medical judgment is not contaminated because virtually all drug companies structure “spreads” for doctors who buy and dispense drugs and these spreads are virtually all the same. This is a more honest and convincing argument.
The fact that the attorneys general of Minnesota and several other states have brought legal action against several pharmaceutical firms is evidence of failure by the federal agencies that administer Medicare and Medicaid. They wrote the rules specifying how reimbursements were to be based on posted average wholesale prices. They obviously have not implemented an effective control or auditing system to ensure that these claimed prices accurately reflect what firms really charge providers.
Such an audit program need not involve hiring battalions of civil servants. The Arthur Andersen debacle aside, auditing is a function that is relatively easy to contract out to public accounting firms. Many such firms could implement audit programs to cover both drugs dispensing physicians and manufacturing firms at moderate cost. Competent auditing could ensure that average wholesale prices were just that and not the “ain’t what’s paid” so common today.
Prohibiting doctors from charging any markup over the drug manufacturer’s price would add transparency to the process. These doctors may respond that existing “spreads” are necessary income for them to run their practices. Economists agree that if prohibiting the charging of spreads cuts doctors’ incomes, the quantity of doctors supplied will decrease.
If we need existing levels of income to motivate enough people to be doctors, then doctors can raise their professional fees. But burying fees in fraudulent “spreads” reduces effective market information and reduces efficiency. And we may need to look for any artificial barriers to entry into the general medical profession or specific specialties such as oncology that might restrict supply and raise charges.
Another measure would be for government agencies to bargain directly with drug manufacturers on prices or to establish a “formulary” of the lowest-cost but effective drugs approved for reimbursement under Medicare. Canada and many European countries use some variation of this measure.
Drug firms argue that this will reduce incentives for research and development of new pharmaceuticals. Economists generally agree. And it reduces doctors’ autonomy to choose the exact drug to best meet specific patients’ needs.
Moreover, lags in bureaucratic approval generally mean that new drugs are not available as quickly as in other systems. Despite some lawmakers’ admiration of this system, it is not likely to be adopted soon in the United States and it is not clearly preferable from the point of view of society as a whole.
© 2002 Edward Lotterman
Chanarambie Consulting, Inc.