The Inflation Reduction Act (IRA), signed into law by President Biden on August 16, 2022, is one of the most significant pieces of healthcare reform since the Affordable Care Act. Three of the bill’s provisions are of particular importance for private equity investors:

(i) the requirement that the Department of Health and Human Services (HHS) negotiate the maximum price of certain prescription drugs and biologics;

(ii) caps on out-of-pocket spending on prescription drugs for Medicare Part D beneficiaries; and

(iii) the requirement that drug manufacturers pay a Medicare rebate if they raise prices by more than the rate of inflation.

We discuss these provisions and their potential implications for private equity investors, below.

HHS Negotiations for Prescription Drug Prices

Medicare principally covers prescription drugs through Parts B and D. The Part B program provides reimbursement for prescription drugs that are administered on an outpatient basis, such as in physician offices and clinics. HHS currently reimburses Part B drugs at a rate of 106 percent of the drug’s average sales price (although, when budget sequestration has been in effect, that rate has dropped to 104.3 percent). Part D covers drugs that senior citizens obtain from pharmacies. Part D plans are operated by private insurers (with government subsidies). Currently, each Part D plan separately negotiates the price of the drugs it purchases for its beneficiaries.

The IRA significantly alters the current framework. Rather than using a formula to determine the reimbursement of Part B drugs and letting private insurers negotiate prices for Plan D drugs, HHS will be required, starting in 2026, to negotiate the price of many of the Part B and Part D drugs that account for the highest Medicare spending. Under the IRA, HHS must negotiate the price of 10 Part D drugs starting in 2026, 15 additional Part D drugs in 2027, 15 additional Part B or Part D drugs in 2028, and 20 additional Part B or Part D drugs in 2029 and beyond. Qualifying products will be chosen from a list of the 50 drugs with the highest total Medicare Part B spending and/or the 50 drugs with the highest Medicare Part D spending. Products are only subject to negotiations if they are not subject to generic competition and have been on the market for a designated period of time—nine years for small molecules and 13 years for biologics (large molecules).

Any drug selected by HHS for “negotiations” is automatically subject to a statutory maximum price, which is the lesser of: (i) the amount at which the drug would have been reimbursed by Part B or Part D under the old regime and (ii) the average non-federal average manufacturer price in 2021 (adjusted for inflation). There is no statutory minimum. When negotiating, HHS is instructed to consider the cost of developing the drug, the cost of manufacturing the drug, and the availability of alternative treatments. The IRA notably seeks to insulate from judicial review HHS’s decisions regarding which drugs to select and its maximum price determination, although it remains to be seen if this provision survives judicial scrutiny.

Companies that fail to comply with the negotiation provisions of the IRA may be subject to a punishing excise tax, unless they opt to withdraw their drugs from Medicare and Medicaid coverage—an unrealistic option for most companies. The tax starts at 65 percent of the drug’s U.S. sales and may be increased by 10 percent per quarter up to a total of 95 percent of U.S. sales. Further, failure to offer the negotiated price to eligible individuals or their providers may result in a civil monetary penalty of 10 times the product of: (i) the number of units dispensed over the relevant period and (ii) the difference between the maximum fair price and the price actually charged.

Investor Considerations

If not altered by Congress before going into effect in 2026, the IRA is likely to have a deleterious effect on the manufacturers of successful drug and biological products that meet the criteria for HHS negotiations. The Congressional Budget Office estimates that this provision will save the Medicare program $100 billion over ten years; the life sciences industry will suffer corresponding losses. Those losses will increase if, as seems likely, commercial insurers attempt to use the HHS negotiation process as a basis for reducing the amount they pay for the subject products. In addition, the IRA creates a new layer of uncertainty for the life sciences industry: HHS’s decision about which products to select for negotiations and HHS’s determination regarding how far it wishes to deviate from the statutory maximum price may be influenced by the preferences of the HHS Secretary at that time.

Investors should carefully consider whether a target’s portfolio includes drugs that are likely to be subject to the IRA negotiations provision. Moreover, investors should ask whether life sciences companies have any plans that may mitigate the impact of the IRA, such as whether companies intend to:

• launch an authorized generic, meaning there would no longer be a single source product on the market;
• launch a redesigned branded product into the market;
• decline to sell the product to any federal healthcare program; or
• agree to pay the excise tax (a theoretical but unlikely possibility).

If a company is considering any of these options, investors should carefully review any associated potential business and legal/regulatory risks.

Investors should also recognize that the IRA may alter the future flow of capital. The shorter nine-year period of immunity from price negotiations for small molecules, as compared to the 13-year period for biologics, could negatively impact funding for trials of new small molecules. This change could ultimately lead to long-term decreases in biopharma R&D and reduced industry innovation.

Capped Out-of-Pocket Spending for Medicare Part D Enrollees

Prior to the IRA, Medicare provided partial coverage for high out-of-pocket drug costs for Part D beneficiaries. Above the catastrophic threshold ($7,050), the government paid 80 percent of the total cost, private insurer Medicare plans paid 15 percent, and beneficiaries paid the remaining 5 percent. Beneficiaries typically paid an average of $3,000 to reach the catastrophic threshold and there was no upper limit on the total out-of-pocket expenses that beneficiaries could accrue annually.

The IRA makes two major changes to this framework. First, in 2024, the 5 percent beneficiary share in the catastrophic phase will be eliminated. Second, the law will impose a $2,000 per year out-of-pocket spending cap for Part D enrollees beginning in 2025. Once an enrollee hits this cap, the government’s responsibility will decrease to 20 percent, the plan’s responsibility will increase to 60 percent, and manufacturers will be liable for the remaining 20 percent.

Investor Considerations

This provision could have cross-cutting effects. On the one hand, it may lead to increased purchasing of drugs by certain Part D beneficiaries whose contributions are now capped. Any such increase in manufacturer revenue, however, may be outweighed by added cost sharing to be imposed on manufacturers when patients exceed their out-of-pocket maximum.

Medicare Rebates for Increasing Drug Prices

The IRA provides that starting in 2023, manufacturers that raise the prices of Medicare Part B or Part D drugs in excess of the rate of inflation will be required to pay a rebate to the government. The rebate program will apply to single-source drugs and biologics (including biosimilars) under Medicare Part B and most covered drugs under Part D. If a manufacturer fails to pay the required rebate within 30 days of receiving an invoice, it will be subject to a minimum penalty of 125 percent of the rebate amount.

Investor Considerations

Investors should inquire as to whether and how life sciences companies are considering adjusting their drug pricing strategies in light of the IRA (as well as state-law drug pricing measures that have been enacted in recent years). Since the rebate provision is based on price increases, investors should evaluate the starting price of the drug in question in order to assess the impact of potential constraints on future price increases. In addition, it will be important to verify that companies have developed appropriate processes to make timely rebate payments.