When President Joe Biden signed the Inflation Reduction Act (IRA) into law on Aug. 16, 2022, it was the culmination of a long, strange journey for legislation that had been debated for over a year. That it happened at all took most observers by surprise, as Sen. Joe Manchin acknowledged after he announced that he would back the bill.
The IRA contains significant provisions altering the landscape for prescription drug pricing and patient access in Medicare, as we covered here. The ZS Research Center has been studying this policy and its implications. In this article, we take a macro perspective on the impact of the legislation for biopharma. We will make three claims:
- Most industry observers believe that the IRA’s impact on the drug industry will be modest.
- Those observers are wrong. The risks to drugmakers are significantly greater than many appreciate.
- There are several steps drugmakers should take to mitigate the risks associated with the IRA and the treacherous environment in which the industry finds itself.
Before Manchin’s abrupt turn, the legislation that became the IRA was considered dead. So Manchin’s announcement in late July was a significant disclosure of new information affecting the drug industry’s earnings prospects. Yet equity markets reacted with a shrug. On July 26, 2022, one day before the announcement, the S&P Pharmaceuticals Index stood at 4,931. At close of trading on Oct. 14, 2022, that index was down 5% to 4,667. The broader S&P 500 was down 9% over that same period, so biopharma has outperformed the market since the unexpected resurrection of the IRA drug pricing provisions.
Equity analyst reports have been consistent with this limited-impact story. They highlight the fact that the price negotiation provisions don’t come into effect until 2026 and would be modest at first. They also argue that the Medicare Part D benefit redesign will be neutral or even positive for the industry, trading higher rebate obligations in the catastrophic phase with better patient access due to the new $2,000 annual out-of-pocket cap. The view of Part D redesign as an industry opportunity is bolstered by the fact that pharma industry lobbyists have supported capping Medicare enrollee annual costs.
Also supporting the notion of limited industry impact, the Congressional Budget Office, in a much-cited study, estimated that the IRA’s provisions would have a nearly negligible impact on drug development, projecting a reduction of just 1% in new drugs coming to market over the next 30 years. The takeaway from that analysis seemed clear: Industry claims that price controls could stifle future innovation were nothing but typical alarmism.
Beyond the generally well-known and understood impacts of the IRA, we believe there are three categories of risks to the industry that are underappreciated. When putting these together, we conclude that the emerging environment is quite treacherous for pharma and that the risks are greater than the market reaction to date would suggest.
Risk category 1: Potential downsides in the IRA’s implementation
The IRA legislation provides the frame for a new pricing regime in the United States, but lawmakers have left it to the Department of Health and Human Services (HHS) to paint the full picture. The government is currently organizing itself for the implementation, and at this stage, the most salient details remain to be determined through the rule-making process and beyond. In those, two areas emerge as the biggest sources of potential downside beyond baseline expectations.
First, the statute describes a “maximum fair price” that the HHS secretary is authorized to accept during drug price negotiations, but no details are provided about exactly how a price will be determined somewhere between $0 and that statutory maximum. Many impact assessments assume a baseline outcome of this price negotiation to be the maximum fair price. However, the structure of the negotiation rules provide few viable alternatives to drugmakers other than accepting whatever price the government offers, so there is significant downside risk of prices dropping below the maximum fair price. Below, we show how the IRA would affect cumulative life cycle revenue for four drugs under different price negotiation outcomes. Prices significantly below the statutory maximum can bring significantly greater value erosion.
Second, while the IRA was intended to affect prices in Medicare, the mechanisms through which negotiated prices are realized in the marketplace may cause unavoidable spillover into other market segments. This is a risk particularly for medical benefit/Part B drugs. The law requires manufacturers to make negotiated prices available to providers who purchase drugs for usage in their facilities. However, there is no mechanism in today’s marketplace for delineating between Medicare and non-Medicare patients at point of purchase. Further, even if such a mechanism emerged through the rule-making process, the average selling price of a negotiated drug would drop dramatically, leading to declining reimbursement in the private market and putting downward pressure on commercial prices. If these issues are not addressed in rule-making, Medicare negotiated prices may become the prices across the market. This could increase the total downside of price negotiations by 25% to 50% in therapy areas that skew older (for example, medical oncology) and by 100% or more in therapy areas that skew younger (for example, immunology).
Finally, some have noted that the scale of price controls ramps up slowly and the full impact will take several years to realize. While this is true, drug development and commercialization is a long game and by the time drugs in development today come to market, they will be operating in an environment where the lion’s share of eligible Medicare spend will be subject to negotiation.
Risk category 2: Deterioration in the market environment in response to the IRA
While the headline change in the Medicare Part D benefit redesign is the introduction of a $2,000 out-of-pocket annual cap for patients, there is also a big change coming in cost responsibility by coverage phase. Most importantly, health plan responsibility in the catastrophic phase will be increasing from 15% to 60% as shown in the figure below.
This shift will induce significant behavioral change from the Part D plans. In our discussions with plan representatives, they pointed to the following expected behaviors:
- Dramatically more aggressive utilization management in high-cost categories
- Narrow formularies for branded drugs
- Expectation of higher rebates from manufacturers to partially offset new costs
- Formulary distortions that will discourage many high-cost patients from enrolling
Market leaders in particular will experience a more difficult access environment in the new Part D world. We expect that many plans will prefer drugs with less market demand as a mechanism for reducing enrollment of patients with preexisting conditions. While Part D plans must include at least two drugs in each category on their formulary, they may select drugs with total market share of a few percentage points, rather than market leaders. Their new economics will strongly encourage those sorts of choices.
Further, newer drugs in categories with negotiated products may find themselves boxed out of Medicare coverage. The IRA requires health plans to cover any drug that has gone through the negotiation process. If there are two such drugs in a category, a Part D plan may not make space for other competing options, even for clinically compelling treatments.
Putting these pieces together, one plausible scenario is a U.S. Medicare business that trends toward utilization management akin to Medicaid for pharmacy benefit therapies, especially outside of protected classes.
Risk category 3: Further deterioration in the policy environment
- Subjected at least 50 drugs to price controls each year
- Incorporated international price referencing
- Instituted price negotiation as early as launch, rather than allowing nine (small molecule) or 13 (biologic) years of pre-negotiation pricing
- Made negotiated prices available to private insurers unless they opted out
These differences provide a roadmap to areas of further risk. “Now that mandatory negotiation is established as yet another tool the government can use, it is not unlikely that this mechanism also may be expanded over time,” experts at law firm Latham and Watkins wrote. “H.R. 3 contemplated that 50 drugs would be subject to negotiation every year, and it remains possible that subsequent legislation will increase the number of drugs or reduce the price cap.” Policy advocates like Steve Pearson at the Institute for Clinical and Economic Review (ICER) are already making the case that Congress should tackle launch prices next.
While the IRA sets a new baseline, drugmakers will have to contemplate scenarios in which more drugs are subjected to price controls earlier in their life cycles and in which other non-Medicare populations are incorporated into those controls as well. The IRA’s passage also exists in the context of other negative policy changes for the industry both in the U.S. and beyond. In the U.S., gross-to-net risk continues to grow with the 100% cap on Medicaid rebates about to be removed and increasing costs from 340B rebates and co-pay accumulators/maximizers with little policy relief from these expenses. Outside the U.S., the worsening economic environment and health budgets put opportunity at risk, too. For example, Germany has just passed a law that will toughen the pricing environment dramatically.
Drugmakers are already gearing up to adapt to IRA implementation. We see companies updating their product forecasts, looking at their risk exposure and planning for the wide array of tactical activities that will be required to comply with the IRA. Beyond these necessary actions, we suggest three areas where companies should focus their energies and two critical moves in each:
- Get the IRA response planning right.
- Double down on launch effectiveness.
- Make the difficult organizational investment and resourcing decisions.
Critical move 1: Enterprise policy scenario planning
The IRA impact is wide ranging, touching on disease area focus, clinical development strategy, pricing decisions, market access and distribution, to name a few. Further changes to the policy environment could affect many of these same areas. The set of possible policy changes or IRA implementation details is too broad to truly cover comprehensively. However, leaders must define a set of plausible scenarios that can be used to pressure test major decisions. For example, one scenario might have a reduction in the time window before price negotiation commences, while another scenario may contemplate spillover of the Medicare pricing rules into the non-Medicare business.
These scenarios should be developed with the full enterprise in mind, and planning should be done in a coordinated fashion, so that all stakeholders are starting from the same premises and assumptions. For major decisions, such as pivotal trial designs or product acquisitions, there should be sensitivity assessments across prioritized scenarios. Simply assessing decisions with a post-IRA baseline will not be enough to support long-range decisions.
So far, we have seen many organizations acting in a too-decentralized fashion. Different groups sometimes make different assumptions about the same dynamic. For example, business development forecasters, early asset forecasters and in-line forecasters may make different assumptions about net price growth given the IRA inflation price increase caps. Or an oncology franchise may make different assumptions than a general medicines franchise. Reconciling these sorts of differences will be burdensome enough with only a single baseline scenario. With multiple policy scenarios, some degree of centralized planning and management is essential.
Critical move 2: IRA implementation policy advocacy
The risks laid out above yield a focused set of priorities for advocacy in the rule-making process for IRA implementation. Four such priorities are:
Clarity. Drugmakers need clarity about how the Medicare price negotiation process will work. How will the drugs be selected from the list of eligible options? How will data about a drug be used in price determination? How will determinations such as the two-year biosimilar introduction likelihood be made? The more details can be laid out in rule-making versus being open to ongoing discretion, the better the industry can plan its own activities.
Real negotiations. The lack of any price determination mechanism or price floors in the IRA coupled with the punitive excise tax creates the prospect of sham negotiations. Drugmakers should seek rules that ensure a good-faith negotiation process where drugs that demonstrate greater value will realize higher prices.
Containment to Medicare. The IRA passed the U.S. Senate under a reconciliation process where policy changes needed to affect the federal budget or they were excluded by the Senate parliamentarian. The extension of negotiated prices to commercial plans was removed from the IRA for this reason. Drugmakers should advocate that this principle be upheld in the law’s implementation. This is a particular concern for medical benefit drugs where today’s drug acquisition and reimbursement model does not allow for a neat delineation of Medicare and non-Medicare usage.
Preserving a quality Medicare drug benefit. The new Medicare Part D benefit design places most of the burden for high-cost drugs on the Part D plans, increasing their cost share in the catastrophic phase from 15% to 60%. Health plan leaders have told us that this will lead to more aggressive and restrictive drug utilization management, as well as some potential distortions in which drugs are preferred on plan formularies. These changes risk limiting real-world access to the drugs that doctors are most likely to prescribe for their Medicare patients in leading categories. Drugmakers should advocate for high-quality Medicare formulary requirements and a limit to onerous utilization management protocols for nonpreferred drugs.
Critical move 1: Strengthen new product pricing and value communication
With limited price flexibility post launch, drugmakers will look to optimize their launch pricing in the new environment to mitigate the IRA’s downside impact where possible. In highly competitive categories like diabetes or immunology, the market will play a significant role in setting acceptable gross and net price thresholds. In oncology or rare disease categories, companies may look to set higher prices at launch than they otherwise would have absent the IRA. Those who do will need to tread cautiously, given the systemic risks of U.S. price controls making their way earlier into the drug life cycle.
There is already a significant spotlight on drug launch prices spurred by groups like ICER and by the research of opinion leaders like Rome, Egilman and Kesselheim who have pointed to large increases in drug launch prices over the past several years. While the research itself is quite shoddy, the talking point remains and drugmakers must expect a brighter spotlight on launch pricing.
The industry has long struggled to tell compelling value stories that support their U.S. pricing decisions, often relying on high-level claims about research expenditure, disease burden, value and the need to encourage drug innovation. These bromides failed to stem the tide of the IRA, and they may fail again if a new Congress takes up launch pricing. Drugmakers need to develop much more compelling stories about the value of the innovation they are bringing to market and begin engaging more actively in pricing and value frameworks, lest those choices be made by others who appreciate pharma’s positive impact less.
Critical move 2: Launch aggressively and effectively
Launching new drugs has become increasingly difficult in recent years, especially those that are not first in disease or in class with the clear majority of such treatments not meeting expectations. Even before the IRA’s passage, early performance in launches has been challenged by slow payer coverage and by the long trend of degrading access to prescribers. Some have suggested setting less aggressive early performance expectations, potentially slowing down commercialization investment and evolving to more of a “pay as you grow” approach.
These ideas, questionable before the IRA, must be rejected more strongly now. When the length of time at peak sales is shortened, it becomes even more important to reach peak rapidly. A slow seven-year build to peak will leave precious few years of high revenue, especially for small molecule therapies. Companies that excel at launch may also find themselves the beneficiaries of less competitive small molecule markets if others who struggle to gain rapid traction choose to exit those categories.
Critical move 1: Rebalance the portfolio to move from safety to growth
The reality is the IRA will significantly impact both return on development programs and inorganic growth. The difference in negotiation window, inflation penalty, orphan protection and level of Medicare exposure will fundamentally alter how companies choose to rebalance their portfolio. Yes, there are many uncertainties around rule-making and implementation, but even conservative baseline assumptions already point to a reality that some existing development programs will no longer be viable. Companies will need to assess their current investments and focus areas in light of these emerging marketplace realities.
Alnylam’s decision to cull a promising phase 3 program to preserve the orphan disease exclusion (where the asset would not be subject to negotiation so long as it only pursued both a single indication and an orphan one at that)—specifically cited by the company as IRA-driven—is just a first public example of the kinds of adjustments that drugmakers must make now. This can potentially involve many parallel moves, including:
- Pivoting from certain diseases (and by extension therapeutic categories) with potentially value-destructive negotiation potential
- Shifting from “long windup” life cycle management (LCM) development to accelerating with shorter lead times between initial FDA approval and top indication authorization, even where risky
- Deliberately reassessing the where and how of small molecule technology
Asset/technology value choices:
- Considering “cousin” molecules that are pursued separately and in parallel where starting the clock at first indication launch would damage LCM development
- Reassessing biosimilar competition approach, given the two-year negotiation exemption
Structure and deal choices:
- For 2026 to 2028: Relying on single-product emerging pharma to shield value before the exception expires in 2029
- Moving away from transaction structures that rely on price growth over inflation
Critical move 2: Make the IRA a tipping point for cost containment and operating model change
Removing the IRA from the equation, the pharmaceutical industry is already in a moment of unprecedented economic pressure that has experts predicting a need to strip out over $30 billion in selling, general and administrative expenses by 2030. Some of the main drivers include:
Patent cliff. The next eight years represent the biggest impending patent cliff in industry history. Five of the top 10 biopharma companies have more than 50% of their revenues at risk. Adjusting for projected pipeline value through 2026 does little to avert the situation by company. While companies will make necessary maneuvers to blunt the effects, the big difference this time around is the science won’t save the financial picture as it did when biologics followed the small molecule patent cliff. Exciting technology is launching, but with much different commercialization models, cost structures and margin profiles (for example, cell and gene therapies, platform technologies) than biopharma is used to with traditional assets.
Blockbusters and asset return. It’s no secret that the number of blockbusters has been decreasing, making revenue recovery from the patent cliff more elusive without significant “asset as portfolio” strategies or in the case of some rare gene therapies, structured geographic expansion. ZS analysis also shows that the return of any given blockbuster has lessened in the last five years versus the prior five years as well: 11% on average across categories and a whopping 47% less in oncology. At the same time, the average size of a launch molecule has gone down. Taking oncology again as a marker, asset value dropped from an average of approximately $469M to approximately $274M in that same time period analysis.
Innovation and competition. One positive in the last two years has been a pivot in the return on internal R&D innovation investment, which has grown from less than 2% in 2020 to about 7% in 2022. This is in part due to efforts in enterprise trial optimization. But with the majority of innovation coming from emerging pharma, the cost of acquisition is increasingly in balance. As we know valuations have been at all-time highs, and inflation is only increasing. Every decision needs to be made with more scrutiny and a higher bar for success.
With the IRA and the strong likelihood of lower revenue potential per drug approved on top of the present economic environment, the equation is simple: Companies will need transformational change to reduce the R&D costs per approved drug, reduce commercialization costs or both.
While impact to revenue, margin and cost varies by company and category, we already see companies feeling the pressure and pulling back on operational costs. But this will not be enough. The IRA can and should be the tipping point for leadership teams to pull the trigger on real and meaningful transformation in R&D speed and return, operating structure and talent and the commercialization model.
Biopharma has a history of weathering challenges, from patent cliffs to category setbacks to reputational challenges, by innovating its way through the storm. While many will be tempted to lean on that legacy and watch and wait, we see the IRA as a call to action now—both in how the industry navigates the law’s implementation and in the bigger picture of the coming headwinds.