Drug Costs Account For Small Part of Nation's Medical Bill
Health care costs have risen significantly in the last few years. The alleged culprit in these cost increases are large increases in drug prices. Unfortunately, there are two major fallacies in what has become a generally accepted explanation of rising medical bills.[1] The first fallacy is that drug prices are increasing rapidly. In fact, drug expenditures have increased at double digit amounts in recent years but this is due to increased drug usage and not to significant increases in prices.
The other major fallacy is that spending on pharmaceuticals represents a major part of total medical spending in the U.S. The reality is that drugs account for a very small portion of the nation’s medical bill. Drugs amount to around 10 percent of medical spending as opposed to hospital care (33 percent), physician services (23 percent), nursing homes (7 percent) and dental, vision, and nonprescription drugs and medical equipment plus public health spending and other items (27 percent).
While it is true that the proportion of health spending on drugs has increased significantly in recent years the fraction of medical expenditures on pharmaceuticals is no higher now than in 1960. Drug expenditures dropped from around 11 percent of total medical costs in 1960 to around 5 percent in 1980. This occurred because the enactment of Medicare, Medicaid and the expanded provision of private health insurance made health care “free” to much of the population. The dramatic reduction in the observed price of medicine caused a substantial increase in the expenditure on health care. The workings of the law of demand are shown by big increases in third party payment as well as the relative drop in spending on drugs since public and most private plans did not cover pharmaceuticals at that time.
In 1980 two-thirds of drug purchases were out of pocket expenses for consumers. By the year 2000 this proportion had fallen to around one-quarter as third party drug insurance coverage expanded rapidly. This was the result of several factors. They included a tight labor market which caused employers to offer more generous fringe benefits, a switch to managed care plans which frequently offered drug coverage as well as technological innovations that allowed for easy insurance billing of drugs at pharmacies and mail order firms. In addition, drug coverage became more common place in many state Medicaid programs. Statistically, 70 percent of the increase in the proportion of medical spending on drugs can be explained by declining out-of-pocket costs for these products.
Since rapid insurance coverage for drugs clearly drove the expenditure increases on them the obvious solution is to sensitize consumers to the actual cost of pharmaceuticals. This can best be accomplished by widespread adoption of “consumer” based health insurance. One way to accomplish this is by switching employees to Health Reimbursement Arrangements (HRAs). These involve offering a high deductible catastrophic coverage plan to workers with a separate employer financed account for the purchase of more routine medical items including pharmaceuticals. For example, the deductible might be $4,500 and the employee account might contain $3,000. Employees with expenses below $3,000 would retain access to their unused funds. Thus, their spending effectively becomes “out of pocket.”
This type of coverage would reveal the true cost of medical goods and services below the deductible of $4,500 to consumers. An employee in need of a particular drug would purchase it out of the $3,000 account. They would now have an incentive to compare alternative, lower cost treatments or question how much they really need the product. This would happen because unused balances would ultimately belong to the employee for future use. The outcome would be a significant slowing of the growth in drug spending. This would restore health insurance to its proper role of protecting consumers from large, unanticipated medical expenses instead of meager co-pays and deductibles that encourage overuse of all health care, including pharmaceuticals.
Notes
[1] Ernst Berndt, “Pharmaceuticals in U.S. Health Care: Determinants of Quantity and Price,” Journal of Economic Perspectives 16, no. 4 (Fall 2002): 45-66.
Michael T. Bond, Ph.D., is Director of the Center for Health Care Policy at The Buckeye Institute and a professor in the Department of Finance at Cleveland State University.
