Optimal incremental cost-effectiveness ratio threshold for a representative consumer: exogenous prices and technology
Our starting point for considering optimal pricing and utilization in a single country is Garber and Phelps (1997) (GP)'s model of an uninsured individual's optimal allocation of a fixed budget between medical care and other services, treating the availability and price of medical technologies as exogenous.
Assume that each country can be represented by an individual with income Y that is constant in real terms across time periods. Following GP, period-specific utility of income as viewed from period 0 is v = U0(Y), before discounting or quality of life adjustment. Income is spent on medical technologies a and b, with prices wa and wb, respectively, which for now are assumed to be exogenous, and on other goods. Consumption of medical care in period 0 affects probability of survival and quality of life in future periods. Future utility is discounted by a factor ρ. The expected benefits of medical care can thus be expressed as the sum of discounted expected future quality-adjusted life years (QALYs), Qi. Expected utility in period 0 can be written
The optimal utilization of technology a using Eq. (1) is defined by the first-order condition:
Optimal utilization thus implies equating the marginal utility cost of spending on a in period 0, , to the marginal expected utility of future discounted QALYs gained from using a, v dQ/da. Rewriting,
In Eq. (3), the left hand side (LHS) is technology a's ICER, assuming no alternative treatment. The numerator is the incremental cost of using a, which here is just wa, but it could include other medical costs (ca ) if use of a affects other services due to complementarity or substitution. The denominator is the expected QALYs gained from using a. The right hand side (RHS) is the ratio of future, period-specific utility v to marginal utility in the base period, or willingness-to-pay (WTP) for medical care. Optimal utilization thus requires equating the technology's ICER to the consumer's WTP for medical care.
Application to a universal payer: endogenous prices and utilization
Assume that each country operates a universal insurance system including drugs for all citizens, to provide financial protection and reflect altruistic concerns for access for the poor. Prices charged by manufacturers and technology availability are now endogenous and influenced by insurance design and payer strategies. The analysis can still focus on the representative consumer, assuming that political processes constrain the universal insurance design to reflect consumer preferences for altruism and personal treatment options.3 Reasonable financial protection for patients requires that cost-sharing is modest and capped. Manufacturers therefore face relatively inelastic demand which, in the absence of constraints, could lead to prices above the patent-induced level without insurance. Assume raising funds is costly, and hence, the payer seeks to achieve second rather than first-best static and dynamic efficiency.
In this context, Eq. (3) implies that the payer can indirectly control prices by setting an ICER threshold K (e.g., £30,000 per QALY) that reflects its citizens' WTP for medical care and limiting reimbursement to products/utilization that meet this threshold:
We assume a manufacturer is permitted to price freely, subject to this constraint. It would set its price differential over current treatment at the highest level consistent with the ICER threshold, given the product's incremental cost offsets and effectiveness gain:
Thus, a new product with no incremental benefit would be constrained to price at w0. A more effective product or one that substitutes for other services could be priced higher and still meet the ICER threshold. The payer's ICER threshold acts as an indirect control on price, given the product's incremental effectiveness and cost offsets.
Given the manufacturer's choice of price, the payer can achieve appropriate use by limiting coverage to those patients for whom the product is cost-effective at this price and ICER threshold. Some products may have a distribution of effectiveness across patient subgroups with different indications or severities. If the firm chooses a high price, the payer would restrict use to patients whose condition/indication implies an expected health benefit sufficient to meet the ICER threshold. A lower price enables the payer to encourage use by patient subgroups with lower expected benefit. The firm thus faces a price-volume trade-off similar to a demand curve. In a single price system, the firm selects the profit maximizing price, given the use that the payer would permit at that price. This outcome is second-best efficient. Static and dynamic efficiency could be enhanced and, at the limit, would be first best, if the firm could vary prices by indication/subgroup, reflecting the drug's differential effectiveness, and the payer could costlessly distinguish and pay the appropriate prices for each indication. Such differential pricing within product may become increasingly feasible as drugs become more ‘personalized’ on the basis of patient biomarkers, and data systems are improved to provide the necessary information at reasonable administrative cost.
Our approach to value-based pricing is similar to that proposed by Claxton et al. (2008), with important differences. First, because our approach is grounded in overall utility maximization, the payer's ICER threshold reflects consumers' WTP for health gain, with the health care system funded accordingly. By contrast, Claxton et al. take the health budget as given, and the ICER threshold reflects the opportunity cost of current resource use. Second, our approach permits prices that transfer all surplus to manufacturers for the duration of the patent, to achieve optimal R&D incentives. (Optimality further assumes that patent terms are designed to achieve an optimal trade-off between current and future consumption and that product-specific R&D investments by government are negligible). Claxton et al. constrain manufacturers to a single price to retain some surplus for payers/consumers during the patent term. With heterogeneous consumers and possibly a non-optimal health budget, their approach could imply weaker incentives for innovation in pharmaceuticals compared with other industries. Third, they focus on pricing in a single country, whereas we address efficient pricing and utilization globally.
Our approach differs from the two part pricing approach put forward by Jena and Philipson (2008) (JP) and Lakdawalla and Sood (2009) (LS) in important respects. We propose that payers constrain prices indirectly, through an ICER threshold, whereas JP and LS assume that payers can observe and use the pre-insurance (counterfactual) consumer surplus for each drug to make an appropriate payment for R&D. We assume that eligibility for reimbursement/utilization is determined by the payer's criteria, whereas JP/LS assume patients' cost-sharing is set at marginal cost and patients select first-best utilization. Our approach reflects actual practice in most public and some private insurance systems, where payers define eligibility for costly technologies and only reimburse for patients with approved indications.4 Jena and Philipson (2013) show how payers setting ICER thresholds (affecting firms' choice of profit maximizing prices and physicians/patients' choice of utilization) can lead to inefficient utilization as prices vary above production cost. They recognize, however, that ICER threshold policies to achieve dynamic efficiency would need to be above production cost to encourage efficient R&D investment but do not say what those policies might be.