At the start of 2005, the U.S. government will lower reimbursement payments made to doctors who administer drugs to Medicare patients in their offices. These changes will have the greatest impact on cancer doctors, or oncologists, and could lead to disruptions and/or slowdowns in sales for companies like

Amgen

(AMGN) - Get Report

,

Genentech

(DNA)

,

Biogen Idec

(BIIB) - Get Report

,

ImClone Systems

(IMCL)

and

Millennium Pharmaceuticals

(MLNM)

that rely heavily on cancer drugs for a bulk of their revenue.

Naturally, this has biotech investors a bit spooked, especially because forecasting the precise impact of these reimbursement changes has been extremely difficult.

In this installment of my continuing series of "Biotech 101" columns, I'll explain in simple terms the changes being made to Medicare reimbursement. Thanks to a recent survey conducted by the investment bank UBS, I'll provide some insight into how doctors may react to Medicare cuts, and in broad terms, how this will impact the biotech sector in the first half of 2005. (Previous "Biotech 101" columns focused on

clinical trials and the

FDA approval process.)

In the old system, Medicare reimbursed doctors for drugs administered in their offices using a formula based on 85% of the drug's average wholesale price. Reimbursement was pegged at 95% of average wholesale price prior to 2004.

But many of these doctors are able to purchase drugs for less than the average wholesale price used by Medicare for reimbursement payments. By pocketing the difference between their "real" drug costs and Medicare's reimbursement, doctors could boost their earnings.

Concerned about rising drug payouts, the U.S. Department of Health and Human Services, the government agency that oversees Medicare, began looking a few years ago at ways to rein in rising reimbursement costs. Ultimately this led to passage of the Medicare Prescription Drug Improvement and Modernization Act of 2003, which, among other things, altered the way the government reimburses doctors for prescription drugs.

Under the new law, Medicare will reimburse doctors for drugs administered in their offices using a new formula based on the average selling price of the drug plus 6%. This new "ASP plus 6%" formula lowers the drug reimbursement costs paid out by Medicare. Because data on average selling price come from drug manufacturers, doctors no longer will be able to profit by purchasing drugs at a discount to Medicare's reimbursement rate.

The changes to the Medicare reimbursement formulas have concerned cancer doctors, or oncologists, the most because as a group, they make up about 50% of government spending on what is known as Part B drug reimbursement.

Medicare drug payments to oncologists grew from $1.2 billion in 1998 to $4.9 billion in 2003, an average of 32% per year, according to UBS. Under the new "ASP plus 6%" plan, the government estimates that payments to cancer doctors (drug payments and service fees) will decrease by 6% in 2005, in the absence of utilization growth, according to the UBS report. (Medicare has taken some steps, including boosting fees paid for doctor's services and instituting pilot demonstration programs, to ameliorate some of these reimbursement cuts.)

Needless to say, cancer doctors have been complaining loudly about these reimbursement cuts. In some cases, doctors have said the cuts may force them to limit or reduce the number of Medicare patients they treat. And this has drug companies, and investors, worried.

If doctors change the way they treat cancer patients or refer patients to hospitals for treatment, it could have an adverse impact on drug sales, especially in the first half of 2005 as everyone gets accustomed to the new rules.

These worries have hurt Amgen's stock price for most of this year. Other biotech firms that also rely heavily on cancer drug sales, including Genentech, Biogen Idec, Millennium Pharmaceuticals,

MGI Pharmaceuticals

(MOGN)

and ImClone Systems, might be affected.

It's almost impossible to precisely predict what will happen next year, but to better-gauge changes to the economics of doctors' practices (and possible impact on drug sales), UBS commissioned a survey of 100 oncologists who treat patients with solid tumors and who will be affected by the Medicare rules. Approximately 60% of doctors polled were in private/group practice; 40% worked in academic/teaching hospitals. According to these doctors, about 47% of their patients claim Medicare as their primary source of insurance, and about one-third of these patients do not have supplementary insurance. It's this latter group, about 15% of the total cancer patients treated, who are most likely to be affected by lowered reimbursement rates because doctors could treat them with less-expensive drugs and/or refer them to hospitals for treatment.

According to the UBS survey:

Eighty-seven percent of academic oncologists and 63% of community-based oncologists stated that lowered Medicare reimbursement would have an unfavorable impact on their practices. Furthermore, 68% of community-based oncologists said they expect to change their handling of Medicare patients, compared with only 30% of academic doctors. Community-based doctors typically pay more to purchase cancer drugs, so they could be impacted to a greater extent by lower reimbursement payments.

Seventy-five percent of community oncologists said they would likely refer some of the Medicare patients elsewhere for treatment, compared with 35% of academic oncologists.

Most of these patients would be referred to hospitals for treatment. When asked if hospitals could handle a large group of new patients, 82% of community oncologists and 68% of academic oncologists said no. This suggests that treatment for some patients might be delayed, which would, in turn, hurt drug sales.

When asked if reimbursement cuts will cause doctors to change their choice of chemotherapy for Medicare patients, 63% of community oncologists and 40% of academics said yes, with 48% of community doctors and 23% of academics saying they might decrease their use of newer, more expensive cancer drugs.

On a more positive front, 10% of oncologists polled said they would accelerate treatment for some patients in advance of changes to Medicare reimbursement, which suggests a stronger fourth quarter of drug sales.

Also, an overwhelming majority of both academic and community doctors polled said they would not change their use of supportive care drugs like those used to treat anemia, low white blood-cell counts or nausea caused by chemotherapy.

Summarizing the results from its poll, the "implementation of these

Medicare reimbursement changes may cause a slowdown in drug utilization in the first quarter of 2005," concluded UBS analysts, led by senior biotech analyst David Molowa. "In addition, we anticipate some disruption in the care of 15% of cancer patients. This represents those patients who have Medicare as their primary source of reimbursement and have no supplemental insurance.

"This may result in treatment with less expensive therapies or patients referred to the hospital," they continue. "By the middle of 2005, we anticipate that oncologists will have adapted to these changes and that oncology product sales will more accurately reflect underlying demand."

The aforementioned stocks, especially Amgen, have been volatile for a long time, in part because of changes to Medicare. The best thing for the stocks is likely some clarity on how doctors will react to the changes, but we won't have that until the new system kicks in.

Adam Feuerstein writes regularly for RealMoney.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

adam.feuerstein@thestreet.com.