National Bureau of Economic Research
NBER Working Paper No. 22338
Strategic Formulary Design in Medicare Part D Plans
By Kurt Lavetti and Kosali Simon
The design of Medicare Part D causes most Medicare beneficiaries to receive fragmented health insurance, whereby prescription drugs and other medical care are covered by separate insurance plans. Fragmentation of insurance plans is potentially inefficient since separate insurers maximize profits over only one component of healthcare spending, despite many complementarities and substitutabilities between types of healthcare. Fragmentation of some plans but not others can also lead to market distortions due to differential adverse selection, as integrated plans may use drug formulary designs to induce enrollment by patients who are profitable under Parts A & B, while stand-alone drug plans have no such incentive. We study whether the design of insurance plans in Medicare Part D reflects these two differences in incentives using data on the universe of Part D plan formularies, drug prices, and Medicare claims data. We find evidence consistent with both hypotheses. Relative to fragmented plans, integrated plans systematically design their drug formularies to encourage enrollment by beneficiaries with medical conditions that are profitable under Parts A & B. However, integrated plans also more generously cover drugs that have the potential to causally reduce medical costs. These large differences in incentives and plan design between integrated and fragmented plans are likely the precursors of substantial differential selection of enrollees, and the basic design of Medicare Part D abets this covert selection.
From the Introduction
A growing share of all public expenditures on health insurance in the US is paid to private companies that deliver public health insurance benefits. Medicare Parts C and D, which account for about one-third of all Medicare expenses, are delivered entirely by private companies, and 39 states have contracts with private managed care organizations to deliver Medicaid benefits (KFF, 2014). Although the intention behind privatization is generally to increase efficiency, in the case of Medicare Part D the split between public and private provision of benefits has also introduced several strategic opportunities for insurers that may have reduced efficiency and increased total costs.
We focus in this paper on insurer behavior in responding to these Part D incentives when designing plans, and not on the resulting consumer behavior or net welfare effects. The selection effect that we identity, however, clearly increases the cost to Medicare, and Part D formularies provide a mechanism for MA plans to select patients by medical condition with surgical precision.
From the Summary and Discussion
Finally, the results of this research are useful for understanding the extent to which the fragmentation of health insurance generally affects plan design, which is the primary channel through which adverse or advantageous selection is likely to arise in insurance markets.
Comment by Don McCanne
The simple conclusion of this highly technical paper is that fragmentation of health insurance - using the example of Medicare Part D drug benefits - results in differences in plan design and incentives that allow insurers to engage in adverse or advantageous selection. The insurers use this to attract the healthy and avoid the sick. This results in reduced efficiency and in increases in total costs.
Although the example used was Medicare Part D drug benefits, the principle extends throughout our entire fragmented health care financing system, heavily dependent on private insurers that use plan innovations to benefit their own bottom lines.
A single payer system obviously does not use plan design to attract the healthy and repel the sick. Everyone is served equitably.