How does the medical device tax affect innovation and the health/medical startup scene?

Comparative effectiveness research is key to reform

When the Affordable Care Act (ACA) was passed on a party line vote several years ago, it included a somewhat controversial provision to tax, at 2.3% starting in 2013, the sale of any medical device classified by the IRS as being taxable. The list of taxable devices includes a wide variety of products such as defibrillators, dental instruments, pacemakers, coronary stents, artificial hips, joints, and knees, surgical gloves, irradiation equipment, and advanced imaging technology. But it doesn’t stop there—patient monitoring, anesthesiology equipment, infusion pumps, and other hospital operating room digital devices are included in the IRS’s taxable device category. “Consumer” devices such as glucose monitors and potentially many upcoming “wearables” will likely also get taxed either now or soon. That’s where things get difficult for innovators and investors who want to offer next generation devices.

The medical device tax was levied partially to hinder the (over) prescription of medical devices. You and I are most familiar with devices like monitoring instruments or mobile phone sensors, but most dollars are spent on devices like stents, replacement knees, spinal fusion screws, proton beam accelerators, PET/CT scanners, etc. About $200 billion is spent on medical devices per year (about one-third the amount spent on pharmaceutical drugs). The idea behind the tax was twofold. One the one hand, Congress hoped to reduce health spending caused by the overuse of devices by taxing them. But in tandem, the influx of new patients into the health care system is expected to create more sales and revenue for device companies, allowing them to compensate for the excise the tax while bringing in more revenue for Uncle Sam.

Therein lies the rub. Because taxes are usually designed to change buying behaviors, many investors—especially those new to health care, and mostly inexperienced in this industry—think that prices for medical devices are now under pressure, with negative impacts on profits. The traditional, more sophisticated, med device investors understand that the taxes will hit margins initially but will spread out over the coming years. The real issue is whether the government is going to increase the tax-based “punishment” for device manufacturers because of overuse. Some investors are pulling back on investments because creating medical devices is difficult, regulated, and expensive. Even a hint that sales will be hit by higher tax burdens dampens investments in the space.

So the startup community fears, with good reason, that investors will rethink their investments and make fewer investments in traditional device companies that meet the IRS classifications. While traditional sectors are already being hit, new products with truly innovative, perhaps cheaper, products will be slower to market as well because the entire ecosystem is being affected.

If allowed to proceed unhindered in a market-driven way, devices can drop drastically in price over the next decade. Ordinary people are using consumer devices to measure vital signs that used to require visits to the clinic. Advances in chips and batteries are cutting the costs of devices by an order of magnitude, or even two. Experiments show ultrasounds to be effective in cases that used to require CT scans. Next-generation patient monitoring devices that are orders of magnitude cheaper than their incumbent counterparts are also demonstrating effectiveness in trials. There’s a huge promise for the use of safe “consumer grade” devices.

But the health care field is not market-driven. The medical device industry has done a good job through a little old-fashioned fear-based marketing about loss of jobs and reduced innovation plus congressional lobbying to make the excise tax generally unpopular.

Fear-based marketing and lobbying will only go so far to protect decades-old business models that encourage overuse of expensive devices. Even with the hundreds of billions spent every year on all kinds of devices, almost no comparative effectiveness research on them is available. For example, we don’t known whether a $5 disposable sensor attached to a mobile device is less safe or less effective than $25,000 purpose-built patient monitoring equipment. Since we don’t know, the FDA and the incumbents win—they can simply imply that not knowing means “unsafe” or “ineffective.” Another wrinkle is that device manufacturers often have cozy relationships with the physicians prescribing their use; that means the incumbent vendors stay powerful and the innovators are actually left out of the conversation. New devices cost less and reduce fee-based revenues (tied to the high costs) for health systems and providers, and that’s not a good thing for some players in the healthcare industry.

You might think that manufacturers can simply pass their 2.3% tax on to customers (like a sales tax), but those customers are giant health systems with very powerful buyer’s partners known as Group Purchasing Organizations (GPOs). Given the stranglehold that GPOs have on the supply chain, we can’t reduce spending on medical devices, nor can the vendors simply raise their rates (the “price pressure”). The excise tax has been problematic because it strengthens the incumbents and prevents low-cost suppliers (innovators) from entering the market; investors don’t want to invest in companies that are entering an industry with price pressures that can’t benefit from free market dynamics.
I think removing the tax is a good idea, but even better would be to figure out how to get real comparative effectiveness research conducted and move to an outcomes-driven device selection model. That’s a fancy way of saying let’s only pay for devices that actually work. While that seems obvious, the incumbents (and the FDA) don’t make it easy, because of long-term contracts they’ve signed with GPOs and health systems.

In short, the tax debate has focused on the wrong areas. We need to get rid of the tax and get back to the central question of outcomes and effectiveness. If we can reduce the stranglehold of GPOs on the supply chain so that newer, more innovative devices can enter the buying process for hospitals, we could probably save a ton of cash.

tags: , , , , , , , , ,