Should Medicare adopt the Veterans Health Administration formulary?

Since January 2006 all Medicare beneficiaries have been eligible to obtain outpatient prescription drug coverage through private stand-alone drug plans (PDPs). We estimate a model of beneficiary demand for PDPs and use it to compute the loss of consumer surplus due to tightening PDP formularies to the level found in the Veterans Health Administration (VA). Under a generous assumption of cost savings attributed to increased bargaining leverage associated with exclusion of more drugs from formularies, we find the loss in consumer surplus to be smaller than the financial savings that could be shared between Medicare and beneficiaries. According to our estimates, Medicare beneficiaries could be compensated for the loss in consumer surplus associated with tighter PDP formularies with the savings generated by such formularies.