The Federal Government’s Deeply Flawed System For Controlling Medicare Costs

Medicare’s hospital trust fund is set to be exhausted by 2024, according to the latest report from the program’s trustees. Federal officials are understandably looking for easy ways to cut spending in the entitlement program in hopes of shoring up its finances.

They believe they’ve hit on one with a two-year-old effort to introduce “competitive bidding” into the process for buying medical equipment.

Unfortunately, the scheme contrived by the feds is deeply flawed. Not only are Medicare’s auctions resulting in the delivery of low-quality or ineffective medical gear — they’re also dampening investment into the research that can yield the next generation of innovative treatments.

The Centers for Medicare and Medicaid Services (CMS) launched its competitive bidding program for medical devices and equipment in 2009. CMS purchases a host of medical supplies and equipment through the auctions — everything from diabetic supplies to sophisticated in-home care equipment.

In theory, an auction should enable the government to spend taxpayer dollars most effectively. Rather than setting arbitrary prices, public officials force private companies to compete for sales. Prices should reflect competitive conditions. Product quality should increase. And the eventual winner of the auction should — again, theoretically — give taxpayers the biggest bang for their buck.

The CMS auction process, however, employs some unconventional rules. And these quirks undermine the market forces that make typical auctions effective — and economically efficient.

Most notably, suppliers’ bids aren’t binding. Companies are free to offer deep discounts on their wares, win a contract, and then decide after the fact not to deliver. There’s no penalty if a bidder doesn’t abide by its commitment. Consequently, the auction process encourages companies to bid so low that they drive out legitimate suppliers. Moreover, CMS chooses as the final price the median among the winning bids, instead of marginal cost, which would drive pricing in a competitive market.

Predictably, the final purchasing prices yielded by CMS auctions are often well below market rates. The analytic literature puts the average winning bid at one-third to two-thirds below competitive prices. The irrational rules governing the process prevent it from producing the market equilibrium price.

Often, the winning supplier doesn’t deliver on the contract. Medicare and Medicaid patients then face acute shortages of vital medical tools.

Further, prices substantially lower than competitive impose disincentives to invest in the research and development of new medical technologies.

The world capital market allocates investment resources in accordance with expected returns. An auction that drives prices below competitive levels inexorably will do the same to investment.

In 2009 — the most recent year for which data exist — federal non-defense programs, chiefly Medicare and Medicaid, shelled out about $10.4 billion of the $34.9 billion the nation as a whole spent on medical equipment. And that share is expected to rise over the next decade to as much as 40 percent.

So CMS’s artificially low prices single-handedly drive down investment in research and development.

In fact, the public healthcare auction process will cause a 12 to 15 percent decline in healthcare R&D over the next decade, according to recent research published by the Pacific Research Institute. That’s equivalent to about $2.1 billion to $3.1 billion every year that’s not going into medical innovation.

A drop in new R&D of that size would lead to an annual loss of about 500,000 life-expectancy years in the United States, a decline that would be concentrated on particular population subgroups.

The total economic cost of that lost investment amounts to $50 billion — a figure substantially greater than the entire market for medical devices and equipment.

Recently, over 240 professors and economists — including four Nobel laureates — signed a letter to President Obama urging him to change the CMS auction process. The White House must heed their calls. If they don’t, current patients will face continued shortages of critical medical equipment — and future patients will be deprived of the next generation of cutting-edge healthcare tools.


Nothing contained in this blog is to be construed as necessarily reflecting the views of the Pacific Research Institute or as an attempt to thwart or aid the passage of any legislation.

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