The Inflation Reduction Act of 2022 mandates that Medicare-covered drug sales will be protected from price increases that exceed inflation, but the mechanics of this “inflation penalty” have generated some confusion.
A top Medicare official recently noted that the per-pill value of the Medicare inflation penalty will be calculated based on average prices across both the Medicare and commercial markets, but the penalty will be paid only on prescriptions reimbursed by Medicare.
In the original text of the Inflation Reduction Act, the inflation penalty would have been paid on sales in both the Medicare and commercial markets, but a decision by the Senate parliamentarian struck it from the final text. Employers feared that step could result in compensating price increases in the commercial market.
A Congressional Budget Office (CBO) score of the final legislation helps quell that concern. It estimates that the Medicare penalty will have spill-over effects for the commercial market, which I previously estimated would reduce commercial drug costs by $31 billion. While the CBO looked only at the tax impact of lower drug prices, it previously estimated that a market-wide inflation penalty would generate more than five times the tax revenue of the Medicare-only penalty. This begs the larger question: What additional savings would be possible under a market-wide inflation penalty?
A study I led for the Council for Informed Drug Spending Analysis shows that extending the IRA penalty to the commercial market would reduce spending on prescription drugs by an additional $145 billion by 2031. Workers would save $35 billion, while employers would save $110 billion in insurance costs.
While there have been bipartisan efforts to apply inflation penalties to the commercial market, most recently led by Senator Chuck Grassley (R-Iowa), these proposals have failed to garner enough support to pass. As the intense partisanship in Congress limits the ability to pass legislation that requires more than 50 votes in the Senate, I propose alternative federal and state pathways to achieve these savings and lower drug costs for workers and employers.
Federal approaches to a commercial inflation penalty
When calculating the inflation penalty, the IRA requires Medicare to look at the average prices across both the Medicare and commercial markets. This is an administratively simple solution: when a drug manufacturer sells a pill to a pharmacy, it doesn’t know whether the pill will be dispensed to a Medicare beneficiary or someone with employer-sponsored insurance, so it sells the pill at one price for all customers. That makes it relatively easy for manufacturers to calculate average prices for all sales rather than try and determine after the fact which pills went to Medicare or non-Medicare patients. This “all sales” methodology has been in place for more than 30 years under the Medicaid program.
Consequently, to avoid paying the Medicare inflation penalty, drug manufacturers must limit their price increases on all sales. They could also decide that the benefits of increasing prices on all sales outweigh the penalties they pay on the Medicare portion, but if more sales are subject to the inflation penalty, manufacturers will face greater pressure to avoid price increases overall. Even if the penalty doesn’t apply to all sales, research shows that when more sales are subject to an inflation penalty, price increases are smaller.
Instead of directly extending an inflation penalty to the commercial market, Congress could augment the IRA’s existing Medicare inflation penalty to have a similarly expansive effect, making it more costly for drug manufacturers to raise prices above the rate of inflation. One strategy would be to simply double (or even triple) the Medicare penalty to discourage price increases. Another strategy would be to expand the Medicare inflation penalty to cover a broader swath of federal sales (such as Affordable Care Act plans, federal grantee purchases, and the like) without fully extending it to the commercial market. Importantly, because both of these approaches touch only federal markets, they would likely need only 51 votes to pass the Senate — meaning the same Senators who voted for the IRA could pass these modifications in the lame duck period after the 2022 midterm elections.
State-based approaches to a commercial inflation penalty
Although states’ ability to directly regulate drug prices has been hampered by the Constitution’s Commerce Clause, states could tax drug price increases above inflation in the same way they tax cigarettes or soda. But unlike cigarettes or soda, these taxes would be assessed on drug manufacturers themselves under model legislation developed by the Pew Charitable Trusts. Administratively, states could leverage the per-pill inflation penalties calculated for Medicare under the IRA to simplify tax collection, making this an almost off-the-shelf policy. If only California and New York taxed drug price increases, that would effectively double the Medicare-only inflation penalty, driving lower drug prices nationwide.
Although a solution by Congress to extend the inflation penalties market-wide may not be politically feasible, states are well positioned to tackle drug price increases. As more sales are subject to inflation penalties, either through federal or state action, price increases will become too costly for manufacturers, lowering costs even for purchases that are not subject to the penalty. The framework provided by the IRA has opened the door to market-wide restrictions on drug price increases, heeding the call from both workers and employers. The stakes are high — $35 billion in greater take-home pay for workers and $110 billion in lower costs for employers — but the path forward is clear.
