One of Kerry’s most extreme proposals, which he repeated in last night’s debate, is to have Medicare use committed-use contracting in the purchasing of prescription drugs, as is now done by the Veterans Administration and many private sector health plans. As Kerry put it last night:

The president also took Medicare, which belongs to you. And he could have lowered the cost of Medicare and lowered your taxes and lowered the costs to seniors. You know what he did? He made it illegal, illegal for Medicare to do what the V.A. does, which is bulk purchase drugs so that you can lower the price and get them out to you lower.

To understand what Kerry is proposing, a little boring background is necessary: There are categories of drugs, called therapeutic classes, which are similar in their mechanism and effects. Examples include cholesterol-lowering drugs called statins (e.g., Lipitor, Zocor, Crestor, Pravachol), proton pump inhibitors (e.g., Prilosec, Nexium, Prevacid), and antidepressants (e.g., Paxil, Zoloft, Celexa, Effexor, Prozac).

What the VA does–and what Kerry is proposing for Medicare–is pit manufacturers of products within certain therapeutic classes against each other, forcing them to compete on price. The least expensive medication(s) within each class are purchased in bulk and placed on the formulary. Access to non-formulary drugs is sharply limited. For example, the VA formulary includes Zocor but does not include Lipitor. Any VA beneficiary who wants Lipitor instead of Zocor needs to show evidence of medical necessity, which involves a lot of paperwork that few physicians are willing to put up with.

This practice, sometimes referred to as committed-use contracting, can dramatically lower drug prices. The federal government’s military health program, for example, is able to buy Zocor 10 mg for 26 cents per tablet. The retail price, by contrast, is more than $2.00 per tablet.

Committed-use contracting should have little or no adverse impact on patient outcomes provided that the drugs excluded from the formulary have close substitutes. Very few patients, if any, are going to suffer any ill effect because they are given Zocor instead of Lipitor. On the other hand, if the drugs not placed on the formulary do not have close substitutes some patients are likely to be hurt. The lower the degree of substitutability, the greater the risk of harm caused by committed-use contracts.

To the extent that committed-use contracting reduces drug prices, it reduces drug companies’ profits. But don’t feel too sorry for the drug companies. As long as there are lots of different health plans out there, pharma companies will do just fine. Pfizer didn’t get Lipitor on the VA’s formulary, but Lipitor is on plenty of other formularies.

The picture changes when we’re talking about Medicare–a program that covers virtually all 40 million elderly people in the U.S. Medicare is a huge program. No other payer in the U.S. is even close in terms of size. Suppose there were only one Medicare formulary. If a drug company’s product were to be excluded from that formulary, it would be a huge blow to the company. There’s no question that drug companies would fight desperately to get their products included. It is difficult to overstate the importance of the Medicare market to drug companies. How low would prices go? 20 cents per statin tablet? 10 cents? 5 cents?

To Kerry and many other Democrats, the plunge in drug prices would be a dream come true. If a modest patient copayment were imposed (say $10.00 per script), many (virtually all?) prescriptions could be provided at zero cost to the taxpayer. What a deal!

But think about the long-term effects on drug development. Forced to seek profits in less lucrative markets (e.g, Europe, Asia, non-elderly Americans), profits at drug companies would plunge. Relatedly (but much more importantly), the incentive to develop drugs in the future would be radically undermined. What company is going to spend a billion dollars bringing a new drug to market if it knows it will have to sell the product to Medicare for 10 or 20 cents a pill?

As I’ve noted before, my family has benefited from advances in pharmaceutical technology during the past decade–advances that probably would not have occurred if a Hillary-style health care system had been created back in the early 1990s. I don’t particularly enjoy spending $80 out of pocket for a Singulair prescription, but it is well worth it. I would pay much more if I had to.

The Medicare prescription drug plan passed by Congress and signed by President Bush rejects the one-buyer approach espoused by Kerry. Instead, the law will create a number of regional health plans, each of which will be free to use committed-use contracting on its own. Because drug companies will be able to sell their products to a variety of different regional Medicare buyers, the need to be included on any one buyer’s formulary is not dire. Consequently, drug companies will not have to lower their prices as aggressively as they would under Kerry’s plan.

I’m sure many of the audience members present at last night’s Town Hall debate use modern medicines–medicines that are a product of a free market system that allows pharmaceutical companies to earn a healthy profit from their innovation. Kerry’s proposal would virtually shut this system down. Bush’s answer to the question about drug prices would have been more powerful if he had pointed this out. Then again, drug companies are so demonized, I can understand why he didn’t even bother.

Update: In response to my statement that “Very few patients, if any, are going to suffer any ill effect because they are given Zocor instead of Lipitor,” one reader writes to say that he achieved much better cholesterol reduction on Lipitor than on Zocor. He makes a good point: For a given individual, the two drugs might be quite different, even if the average effects are similar. The implication is that the adverse health effects of committed-use contracting may be greater than I’ve suggested above.

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