FEDERAL POLICIES AND THE MEDICAL DEVICES INDUSTRY oO 1 > POS O iT ITC WH eh gm 0.2. Bes iS, w OTA Reports are the principal documentation of formal assessment projects. These projects are approved in advance by the Technology Assessment Board. At the con- clusion of a project, the Board has the opportunity to review the report, but its release does not necessarily imply endorsement of the results by the Board or its individual members. CONGRESS, OF THE UNITED STATES 5 Office of Technology Assessment ; # Washington, D. C. 20510 ~ * 2 2 5 “Chnoroct Recommended Citation: Federal Policies and the Medical Device Industry (Washington, D.C.: U.S. Congress, Office of Technology Assessment, OTA-H-230, October 1984). Library of Congress Catalog Card Number 84-601125 For sale by the Superintendent of Documents U.S. Government Printing Office, Washington, D.C. 20402 Foreword a In recent decades, both the range of medical devices and the industry that manufac- tures them have greatly expanded. At the same time, there has been growing Federal involvement in the U.S. health care system. The Medicare and Medicaid programs established in the 1960s have increased the market for medical technologies and have greatly influenced patterns of payment and use. The Federal Government instituted a premarketing approval process for medical devices in 1976. Other activities, such as funding research and development, regulating the providers of medical devices, and providing medical care for veterans, have involved the Government in the develop- ment and purchase of medical devices. Since the late 1970s, congressional committees have been interested in the effects of such Federal policies on the companies that manufacture medical devices. In early 1982, this interest resulted in a request from the Senate Labor and Human Resources Committee to the Office of Technology Assessment (OTA) for an assessment of Federal policies and their effect on the medical devices industry. The Senate Veterans’ Affairs Committee endorsed the request and expressed particular interest in the activities of the Veterans Administration regarding device development and procurement. In preparing this report, OTA staff drew upon the expertise of members of the ad- visory panel for the study, members of the OTA Health Program Advisory Commit- tee, and experts in health policy, industry, research and development, economics, health administration, and medicine. Drafts of the final report were reviewed by the advisory panel, chaired by Dr. Richard R. Nelson; OTA's Health Program Advisory Commit- tee, chaired by Dr. Sidney S. Lee; and other individuals and groups with expertise in the area. We are grateful for their assistance. Key OTA staff involved in the prepara- tion of the document were Jane E. Sisk, Cynthia P. King, John C. Langenbrunner, Katherine E. Locke, Lawrence H. Miike, and Judith L. Wagner. JOHN H. GIBBONS Director iii Advisory Panel for Federal Policies and The Medical Devices Industry Richard R. Nelson, Chair Institute for Social and Policy Studies, Yale University New Haven, CT William F. Ballhaus International Numatics, Inc. Beverly Hills, CA Ruth Farrisey Massachusetts General Hospital Boston, MA Peter Barton Hutt Covington & Burling Washington, DC Alan R. Kahn Consultant Cincinnati, OH Grace Kraft Kidney Foundation of the Upper Midwest Cannon Falls, MN Joyce Lashof School of Public Health University of California Berkeley, CA Penn Lupovich Group Health Association Washington, DC Victor McCoy Paralyzed Veterans of America Washington, DC iv Robert M. Moliter Medical Systems Division General Electric Washington, DC Louise B. Russell The Brookings Institution Washington, DC Earl J. Saltzgiver Foremost Contact Lens Service, Inc. Salt Lake City, UT Rosemary Stevens Department of History and Sociology of Science University of Pennsylvania Philadelphia, PA Allan R. Thieme Amigo Sales, Inc. Albuquerque, NM Eric von Hippel Sloan School . Massachusetts Institute of Technology Cambridge, MA Edwin C. Whitehead Technicon Corp. Tarrytown, NY OTA Project Staff—Federal Policies and the Medical Devices Industry Jane E. Sisk, Project Director Cynthia P. King, Analyst John C. Langenbrunner, Analyst! Katherine E. Locke, Research Assistant Lawrence H. Miike, Senior Associate Elaine J. Power, Intern? Judith L. Wagner, Senior Analyst Kerry Britten Kemp, Health and Life Sciences Division Editor Virginia Cwalina, Administrative Assistant Rebecca I. Erickson, Secretary/Word Processing Specialist Brenda B. Miller, Word Processor/P.C. Specialist Clyde J. Behney, Health Program Manager Roger C. Herdman® and H. David Banta,* Assistant Director, OTA Health and Life Sciences Division Contractors James R. Barth and Joseph J. Cordes, George Washington University Dennis J. Cotter, Georgetown University Health Policy Center Polly M. Ehrenhaft, Washington, DC Hope S. Foster, O'Connor & Hannan, Washington, DC John Hutton, University of York, England IMS America Ltd., Rockville, MD Kaye, Scholer, Fierman, Hays & Handler, Washington, DC Kornmeier, McCarthy, Lepon & Harris, Washington, DC Anthony A. Romeo, University of Connecticut 1Until November 1983. 2Summer 1983. 3From December 1983. “Until August 1983. Contents Chapter Page 1. Introduction and SUMIMATIY . .......coteenenenmman eran ae eee 3 2. Characteristics of the Medical Devices Industry ........... ooo 17 3. Payment Policies for Health Care and Medical Devices... 41 4. Research and Development Policies Related to Medical Devices ............... 77 5. Regulation of Medical Devices by the Food and Drug Administration .......... 97 6. Regulation of the Providers of Medical Devices. . . «ooo 137 7 Veterans Administration Policies Regarding Medical Devices .................. 157 Appendixes Page A. Method of the StUAY «overeat 179 B. Acknowledgments and Health Program Advisory Committee ................. 182 C. The Innovative Process in the Medical Devices Field. ........................ 186 D. Patent Policy Regarding Medical Devices. .............ooovenrenenreeen 191 E. Method Used for OTA’s Analysis of Applications to the National Institutes of Health for Small Business Innovation Research Grants .................... 196 F. The Database of Venture Economics, Inc., on Sources of Financial Capital ..........ooiiininaia 197 G. Tax Policy and Research and Development on Medical Devices. .............. 199 H. Consensus Standards Related to International Trade in Medical Devices ....... 204 I. Governmental Regulation of International Trade in Medical Devices: United States, Canada, Japan, United Kingdom, France, Federal Republic of Germany, and Mexico «ovis 216 J. Glossary of Acronyms and Terms .............co.ovnrnirrae rere: 231 REFEIEIICES - «+ + vv ee eee eee eee eee eee 237 1. Introduction and Summary Medical devices are a striking feature of U.S. medical care. The past generation has seen the de- velopment of a tremendous range of devices whose use has improved or prolonged people's lives and revolutionized medical practice. Some medical devices have enabled people with what would otherwise be debilitating conditions to improve their functioning. Artificial hip joints, for example, have enabled elderly people with crippling disabilities to walk and live independ- ently. Other devices have extended people's lives. The Scribner shunt has permitted long-term hemo- dialysis for end-stage renal disease, and the car- diac pacemaker has controlled certain arrhythmias of the heart. Still other devices have drastically altered med- ical diagnosis and treatment. Starting with auto- mated blood chemistry analyzers, clinical labora- tories have shifted from manual to mechanized procedures, with consequent improvements in the speed, accuracy, and per-unit cost of tests. New imaging devices, such as the computed tomogra- phy (CT) scanner, ultrasound, and mammography, often obviate the use of more dangerous, pain- ful, and costly procedures, such as exploratory surgery. Innovations in needles, sutures, and micro- scopes have greatly improved cataract surgery. The industry that manufactures medical devices in the United States has grown in tandem with these developments. From less than $1 billion in 1958, industry sales grew to more than $17 bil- lion in 1983. Even after adjustment for inflation, industry sales increased sixfold during that period. About 3,500 companies now employ more than 200,000 people, compared with about 65,000 employees in 1958. These changes in the medical devices industry have occurred during an era of growing Federal involvement in the U.S. health care system. The Medicare and Medicaid programs, which were enacted in 1965, have greatly increased health in- surance coverage, expanded the market for med- ical devices, and influenced their development and use. Between 1960 and 1982, primarily because of the growth in Federal programs, the share of medical expenditures paid by third parties rose from 45 to almost 70 percent. The kind of health insurance coverage that has evolved in this country has insulated the buyers and users of medical technologies—mainly phy- sicians, hospitals, and patients—from the cost of many medical services, especially those provided in hospitals. The purpose of health insurance pro- grams such as Medicare is to permit people to ob- tain needed medical care without risking finan- cial ruin. But there is discretion involved in the use of medical technology, and for many devices, insurance coverage has reduced the importance of cost as one of the few factors that motivate discretion. Some devices, especially those asso- ciated with prevention and rehabilitation, are less likely to be covered by insurance than others and may be relatively underused. The Medical Device Amendments of 1976 sig- nificantly expanded the Food and Drug Admin- istration’s (FDA) authority to regulate medical devices for safety and efficacy. This and other Federal activities, such as supporting research and development (R&D), regulating the purchase and use of devices by medical providers, and deliver- ing medical care to veterans, have substantially involved the Government in the market for med- ical devices. Congressional committees have been interested since the late 1970s in the effect of Federal pol- icies on the companies that manufacture medical devices. There has been particular concern that the newly established Federal regulatory process for devices might be harming technological in- novation and small companies. In early 1982, this interest resulted in a request from the Senate La- bor and Human Resources Committee to the Of- fice of Technology Assessment (OTA) for an assessment of Federal policies and their effect on the medical devices industry. The Senate Com- mittee on Veterans’ Affairs, in endorsing that request, raised issues related to the Veterans Ad- ministration (VA) and its role in technology de- velopment and procurement. This report has been prepared in response to those requests. 4 e Federal Policies and the Medical Devices Industry SCOPE OF THE STUDY Medical devices span a vast array of supplies and equipment, from frequently purchased items with low unit cost, such as bandages and syringes, to infrequently purchased items with high unit costs, such as clinical laboratory and imaging equipment. The definition of a medical device used for this study is taken from the 1976 Medi- cal Device Amendments (Public Law 94-295) to the Federal Food, Drug, and Cosmetic Act. Thus, the term medical device refers to any instrument, apparatus, or similar or related article that is in- tended to prevent, diagnose, mitigate, or treat dis- ease or to affect the structure or function of the body. This definition excludes drugs, which achieve their effects through chemical action within or on the body. Medical devices are thus one class of medical technology as defined by OTA.! A wide range of Federal policies helps to frame the social, political, and economic context of the market for medical devices. This report concen- trates on Federal policies that have the greatest leverage over the kinds of medical devices pro- duced and the price at which they are sold: pol- icies pertaining to payment for health care, sup- port for R&D, regulation of the safety and efficacy of medical devices by FDA, regulation of medi- cal providers, and development and procurement of devices by the VA. Policies that extend to the entire economy, such as those regarding taxation, financial capital, patents, and export control, are excluded from detailed analysis. Although these broader policies may affect medical devices, any options for changing them would require an anal- ysis that reached well beyond the confines of the medical devices industry or this report. As background to an analysis of Federal pol- icies regarding the medical devices industry, it is important to note that medical care differs from many other products that are bought and sold. Patients often do not have the expertise to evaluate medical technologies and therefore tend to rely on medical professionals for guidance concern- ing which medical services and devices to use. OTA has defined medical technology to include drugs, devices, medical and surgical procedures, and the organizational and sup- portive systems within which medical care is provided. Photo credit: E. I. du Pont de Nemours & Co. Medical devices encompass a broad range of products, including not only sophisticated, expensive equipment such as computed tomography (CT) scanners, but relatively simple and inexpensive items, such as bandages, syringes, and stethoscopes. Even medical professionals, however, often lack the expertise to assess sophisticated devices, a fact that underlies the regulatory process established by the 1976 Medical Device Amendments. Governmental programs such as Medicare re- flect the social concern that people be able to ob- tain some minimum level of care, regardless of their ability to pay. Benefits from the use of some medical devices and other technologies, especially those to prevent and treat infectious disease, in- clude increases in overall levels of health and pro- ductivity and are thus greater for society than for the individuals who use the technologies. Gov- ernmental public health programs to immunize young children and to test their vision reflect the societal importance attached to the use of such medical technologies. The remainder of this chapter summarizes the chapters in the body of the report: characteris- tics of the medical devices industry, payment pol- Ch. 1—Introduction and Summary © 5 icies for health care and devices, FDA regulation of devices, R&D policies related to devices, reg- ulation of providers, and VA policies regarding devices. Appendix A describes the method of con- ducting the study, and appendix B acknowledges the valuable assistance of several individuals. Ap- pendixes C through I contain material on topics that relate to but are broader than medical de- SUMMARY In recent years, a number of problems have been perceived in the cost, efficiency, quality, and innovation of medical devices, all of which relate in some way to Federal health care policies. Since 1978, U.S. expenditures for medical care have been rising at an annual rate of 13 to 16 percent, much faster than the rate of growth in the U.S. gross national product. Although studies have not documented the precise role of medical technol- ogy in escalating medical care costs,? the adop- tion of new, sophisticated medical devices, such as CT scanners, and overuse of existing devices, such as automated clinical laboratory analyzers, have often been implicated as contributing factors. In addition to concerns about the growth or level of health care expenditures, there is concern about whether the benefits gained in improved health or reduced worry have been worth the costs. This concern stems from the prevalence of health insurance, which has changed the balance between costs and benefits for people who buy and use medical technologies. Health insurance, especially Federal programs, was originally in- tended to make basic medical care accessible to people who might otherwise not be able to pay for it. But recent concerns about costs have muted such distributional issues. And some cost-effective interventions that are not well covered by insur- ance, especially in preventive and rehabilitative care, are probably underused. Issues more directly related to medical devices pertain to the quality of products marketed and used, including their safety and efficacy, and to 2See OTA's report Medical Technology and Costs of the Medi- care Program (342) for estimates of technology's aggregate contri- bution to health, hospital, and Medicare costs. vices: innovative activity, patent policy, tax pol- icy, consensus standards in international trade, and foreign regulation of international trade. In addition to this main report, six case studies of specific devices, a technical memorandum on the policies of the VA, and a compilation of inven- tors’ vignettes are being published in connection with this assessment. continued innovation in the field. Concerns raised in the early 1970s about fraudulent and hazard- ous devices culminated in the 1976 Medical De- vice Amendments to the Food, Drug, and Cos- metic Act. The regulatory process for devices under this act, in turn, has led to concerns about whether such regulation will impede innovation, which has long been a hallmark of the medical devices field, and whether the degree of consumer protection gained is worth the costs. The Federal policies most prominent and prob- ably most influential in the medical devices field have been those pertaining to health insurance programs, chiefly Medicare and Medicaid, and regulation of marketing. As discussed in this re- port, however, policies pertaining to R&D, reg- ulation of providers, and veterans have had a substantial role as well. Federal funding of R&D has been a longstand- ing Federal activity, mainly within the purview of the National Institutes of Health (NIH). Fed- eral R&D in medical devices, as in other fields, has been intended to stimulate worthwhile in- novations that private developers might not other- wise undertake. Federal and State regulation of providers who purchase and use devices was an early response to rising medical expenditures. Such regulation has had two goals in addition to cost containment: ensuring that people receive care of acceptable quality and ensuring that the distribution of fa- cilities is equitable. The Federal Government has sought for many years to ensure that veterans have access to med- ical care, including devices. In carrying out its 6 * Federal Policies and the Medical Devices Industry mandate, the VA has been involved in the full range of activities from R&D through purchase of devices. Because of the many VA medical centers and individual veterans who rely on the agency for devices, the VA has substantial lever- age in the market for many devices. The Federal policies just mentioned are fre- quently inconsistent, as one would expect of pro- grams that have different, often conflicting, goals: ensuring access to medical care for veterans, elderly and poor people; containing the cost of that care; ensuring acceptable quality of care; pro- tecting public health and safety; stimulating worth- while innovations; and minimizing the adverse ef- fects of regulation on manufacturers. This report and the remainder of this summary chapter de- scribe and analyze these policies with respect to their effect on the medical devices industry. A thorough grounding in current and recent Federal policies is particularly important for assessing policy changes that are contemplated or under way. In the area of payment for medical care, tremendous changes are under way that may affect devices. Medicare and some private third- party payers are beginning to pay hospitals a fixed amount set in advance for each case.® The adop- tion of this type of prospective payment method for hospitals may substantially change the mar- ket for medical devices and may have implications for the international trade position of U.S. man- ufacturers. In the process of implementing the new payment system, Medicare is developing policies that will affect medical devices, such as how to pay for capital expenditures and how to ensure use of care that conforms to an acceptable level of quality. Another important policy area is FDA regula- tion of medical devices and the balance between protecting the public's health and minimizing the regulatory burden on manufacturers. Major por- tions of the Medical Device Amendments have yet to be implemented, and implementation of some may not be feasible. *See OTA's technical memorandum Diagnosis Related Groups (DRGs) and the Medicare Program: Implications for Medical Tech- nology (341). Payment Policies for Health Care and Medical Devices In general, health insurance has stimulated the medical devices field by providing a secure and growing market for the products used in medical care. The effects of insurance on the market for specific devices have varied, depending on the coverage of the devices as benefits, the methods of payment for covered devices, and the finan- cial relationship between the payer and provider of care. In recent decades, the sales of devices whose use has been well covered by insurance, such as X-ray and electromedical equipment and surgi- cal equipment and supplies, have grown much more rapidly than sales of devices such as dental supplies and ophthalmic goods, for which patients pay a much greater share of the cost. Medicare and most other health insurance programs cover inpatient hospital care more fully than care pro- vided in other locations, such as physicians’ of- fices and ambulatory laboratories. Some kinds of medical care and their associated devices, such as preventive technologies, eyeglasses, and hearing aids, are excluded from coverage or covered to a very limited extent. Most methods of third-party payment for med- ical care used in the past have encouraged the adoption and use of medical devices because pro- viders have received more payment with greater use of technology. Physicians and clinical labora- tories have been paid by Medicare, some Medic- aid, and many Blue Cross/Blue Shield plans for the charges they have billed, subject to limits set according to the fee levels prevailing in the area. Besides stimulating use of technology, these charge- based payment methods have encouraged price increases because insurers have used recently billed charges to set new levels of payment. Hospitals have traditionally been paid accord- ing to the charges they have billed or the costs they have incurred. Traditional hospital payment methods have encouraged the adoption and use of medical technologies and have discouraged price or cost containment. Recently, however, Medicare and some States have begun to pay hospitals prospectively (i.e., Ch. 1—Introduction and Summary © 7 with rates set in advance of the time when they apply). In October 1983, Medicare started to pay hospitals a fixed amount per admission that varies across 470 different diagnosis related groups (DRGs). The amount now covers only inpatient operating costs; capital, outpatient, and teaching expenses are continuing to be paid on a cost basis for the time being. Medicare's DRG payment system provides in- centives for hospitals to become much more cost conscious in their adoption and use of medical devices and other resources. Whereas hospital payment methods in the past have encouraged providers and manufacturers to emphasize non- price factors, DRG payment encourages them to give more prominence to price considerations. Especially favored by DRG hospital payment are devices that lower the cost of a hospital stay by reducing the costs of services provided or by shortening the length of stay. Hospitals are likely to increase group purchasing, standardize their purchases, and require competitive bidding for equipment and supplies. How DRG rates are changed in future years to reflect changes in prices and technology will af- fect incentives to develop and use new devices. As payment incentives change, many U.S. device manufacturers will face an adjustment in their product development and marketing strategies, from stressing quality to placing more emphasis on price. However, such a change promises to make U.S. devices more competitive interna- tionally if U.S. companies can more effectively challenge foreign ones on the basis of price as well as technology. The exclusion of capital expenses from the DRG hospital payment rate fosters the adoption of durable equipment and facilities relative to more labor-intensive services, with inadequate regard for the total benefits and costs of each. Congress has stated its intention of including capital in the prospective rate by 1986. Another problem is that because Medicare's DRG payment system applies only to operating costs for inpatient care, it en- courages the adoption and use of devices and other resources in settings such as home health care and hospital outpatient facilities, where DRG payment is not in effect. In some cases, such as surgery for cataract removal and placement of an intraocular lens, it is possible that the movement away from inpatient care may reduce cost and benefit the patient. But DRG payment as now established fosters changes in that direction with inadequate regard for the effects on total costs of care or benefits to patients. Policy options can address these problems in specific areas of medical care and device use. One approach would be to develop payment methods with financial incentives that are more neutral with respect to physicians’ decisions to use devices and that encourage physicians to select the least costly settings of use. Currently, for example, physicians have financial incentives to order and perform clinical laboratory tests in their offices Photo credit: E. I. du Pont de Nemours & Co. Automated clinical chemistry analyzers, first developed in the 1950s, improve the speed and accuracy and lower the per-unit costs of laboratory tests on blood samples. Their use, however, has been implicated as a source of rising medical expenditures. 8 © Federal Policies and the Medical Devices Industry and to use procedures associated with new devices for which high fees may be set. Congress could require Medicare to experiment with payment methods for laboratory and physician services that are mindful of incentives regarding the use of different technologies and locations of care. Congress could also encourage Medicare to ex- periment with alternatives to reasonable charge reimbursement of durable medical equipment and to unify payment policies regarding parenteral or enteral nutrition therapy for patients receiving and not receiving home health services. Congress might also consider including capital in Medicare's DRG hospital payment rates, so that hospitals consider the cost of equipment and facilities when making decisions about resources to purchase and use. The above options that address problems in specific areas of medical care and device use would continue payment methods with basic shortcomings. These methods encourage the use of medical technologies, including devices, be- cause providers are paid more for using more serv- ices, and encourage technology use to shift to less restricted, more lucrative locations. The resulting pattern of use of devices and other technologies is unlikely to reflect their relative costs and bene- fits. A different policy approach would be to move Medicare in the direction begun with DRG payment. Congress could encourage Medicare to set overall limits on the amount to be paid for care and to permit providers and patients to determine the use of specific devices and other technologies within that limit. Such methods of per-case or per- person payment could be applied to physician services, all hospital care, or the full range of med- ical care. Regulation of Medical Devices by the Food and Drug Administration FDA regulation of medical devices was intended to protect consumers” health and safety by ensur- ing that marketed products are effective and safe. The Medical Device Amendments of 1976 pro- vided more effective methods for dealing with fraudulent devices and attempted to anticipate and minimize the potential risks associated with in- creasingly sophisticated devices. Congress also in- tended that the regulation impede innovation in the field as little as possible. The Medical Device Amendments provided for regulation according to the degree of potential risk posed by a device. Devices that had been mar- keted before 1976 were to be assigned to one of three classes: Class I, encompassing devices for which general controls such as good manufactur- ing practices were deemed adequate to ensure safety and efficacy; Class II, an intermediate cat- egory, for devices for which general controls were deemed insufficient to ensure safety and efficacy and for which performance standards could be de- veloped; and Class III, for devices that support life, prevent health impairment, or present an unreasonable risk of illness or injury and require FDA approval before marketing. With limited resources, FDA has set priorities in implementing the 1976 Medical Device Amend- ments. By early 1984, while the majority of the medical specialty classification panels set up by FDA had completed classification of the device types‘ assigned to them, the others had only pro- posed classifications. Twenty-seven percent of the device types are in Class I; 64 percent are in Class I; and 8 percent are in Class III. To obtain FDA's market approval, all Class III devices are required to show evidence of safety and effectiveness. However, preamendments Class III devices were given a 30-month grace period before FDA could require such evidence, and FDA may extend that period. Furthermore, until evi- dence is required for their preamendments equiv- alents, postamendments devices found “substan- tially equivalent” to Class III preamendments devices may be marketed without additional proof of safety and effectiveness. FDA could have expedited the classification of potentially high-risk Class III device types within each medical specialty category, thereby starting the grace period after which evaluation of Class *A device type may include all products of a particular type (e.g., cardiac pacemakers) or grouping of devices that are similar (e.g obstetrics-gynecology specialized manual instruments). Ch. 1—Introduction and Summary © 9 III preamendments devices of these types could begin. Instead, FDA has completed classifications of device types in the medical specialty catego- ries in which most of the device-associated deaths and injuries have been and continue to be re- ported—e.g., cardiovascular (pacemakers, heart valves) and obstetrics-gynecology (intrauterine devices (IUDs)). Furthermore, in September 1983, FDA expressed its intention of reviewing evidence of safety and effectiveness for 13 preamendments Class III device types that it considers of highest priority. Documentation of safety and effective- ness of products of these types will be needed for their continued marketing. Another of FDA's priorities has been to imple- ment the premarket approval process for post- amendments Class III devices. Guidelines for the procedures by which investigational Class III devices may be tested and evidence gathered had been completed by FDA by 1980. FDA's premarket approval process has been ap- plied to only a small fraction of the devices mar- keted after 1976. Postamendments devices that are found substantially equivalent to a device already on the market are automatically classified and reg- ulated like their preamendments equivalent. By the end of fiscal year 1981, only about 300 of the 17,000 products submitted for clearance to FDA after 1976 had been found not substantially equivalent. Although products that are not sub- stantially equivalent are automatically placed in Class III, the manufacturer can petition FDA for reclassification, and some manufacturers have done this. No performance standards have yet been de- veloped for Class II devices. In practice, there- fore, Class II devices have been regulated like Class I devices. In mid-1983, FDA identified 11 priority Class II device types for which it was starting to develop the first performance stand- ards. There is a consensus among industry and consumers that although an intermediate class of devices is advisable, it is impractical for FDA to formulate performance standards for the more than 1,000 device types now designated as Class II. 25-406 0 - 84 - 2 Other examples of how FDA has set priorities in implementing the Medical Device Amendments can be cited. In 1980, for example, FDA exempted 30 Class I device types in the General Hospital and Personal Use category from the requirement that their manufacturers notify FDA before mar- keting them. The manufacturers of these device types, which include medical absorbent fibers and specimen containers not represented to be ster- ile, continue to be subject to FDA registration and surveillance for conformity with good manufac- turing practices regarding manufacture, packing, and storage. Substantial negative effects of the 1976 Medi- cal Device Amendments on the medical devices industry have not been documented to date. Per- haps this result is not surprising, because major sections of the law have not been fully imple- mented. Patents on medical devices, one indicator of innovative activity, have shown the same trends as before the law, with a higher rate of awards continuing for more sophisticated devices. Manufacturers have reported increases in R&D, sales, and new devices introduced since the Med- ical Device Amendments, and national data bear out these reports. One-third of the manufacturers responding to a national survey in 1981 had entered the industry after the amendments, and 80 per- cent were optimistic about business in the field during the next decade. Surprisingly, however, almost half of the survey respondents stated that Federal regulation had been a major problem for them. The regulations have been more burdensome to small manufacturers than to large ones; smaller manufacturers reported higher regulatory costs per employee than larger ones. Small establish- ments are particularly important in the medical devices field: about 70 percent of all establish- ments have fewer than 20 employees, and these small establishments have historically accounted for substantial innovation. The law expressed par- ticular concern about small manufacturers by re- quiring that FDA establish an office to provide them information. Although large manufacturers in the 1981 survey were much more likely to con- sider producing a Class III device, it is noteworthy 10 * Federal Policies and the Medical Devices Industry that this situation existed before the amendments as well. Thus, regulation may intensify this pat- tern but did not originate it. The amendments have posed the greatest prob- lem for small manufacturers of contact lenses. Be- cause some contact lenses were regulated as drugs before 1976, the newer types of lenses were auto- matically placed into Class III. Over the years, small manufacturers have found it difficult to en- ter the market because of the expense of gather- ing clinical evidence on safety and effectiveness. The public policy goals at odds in this case are preserving the confidentiality of information from manufacturers who have already received ap- proval to market their devices versus increasing the availability of products, with price competi- tion as one result. Available information does not permit an assessment of consumer protection under the Medical Device Amendments. Although the pri- mary goal of the amendments is to protect pub- lic health and safety, there exists no systematic information on the extent to which problems of safety and effectiveness are occurring. Without such information, one cannot assess the effect of FDA's choice of priorities in implementing the law. Information from FDA's present voluntary system of reporting device hazards and from prod- uct recalls is inadequate, because it does not in- dicate the magnitude or frequency of device- related problems. Voluntary reports and recalls for high risks have mostly involved implantable devices, often with electrical problems, and car- diovascular devices. Since 1980, FDA has pro- posed several approaches to mandatory reporting by manufacturers and expects to issue a revised proposal in 1984. Congress has several options to improve FDA's regulation of medical devices. Insofar as an overall regulatory approach is concerned, Congress could continue the basic framework and intent of the 1976 law and adjust specific provisions to reflect judgments on the appropriate balance between methods of ensuring safety and effectiveness and the costs of these methods. An alternative strat- egy would be to revise the law to reflect the status quo with regard to FDA's implementation of the law. A third approach would be to revise the law to exclude certain device types from regulation on the basis of their potential risk. To address the issue of what evidence of safety and effectiveness should be required for preamend- ments Class III devices, Congress could continue FDA's emphasis on high-priority device types, limit requirements for evidence of safety and ef- fectiveness to device types identified as problems, or encourage FDA to accept a greater range of evidence. To address the issue of when the evi- dence should be required, Congress could allow FDA to continue its interpretation that the end of the grace period is the earliest date that FDA can require evidence, or could establish the end of the grace period as the date when FDA must call for evidence. Other congressional options per- tain to possible revisions in the substantial equiv- alence method of market entry for postamend- ments devices. There is widespread agreement that perform- ance standards cannot be developed in a timely fashion for all of the devices types that have been placed in Class II. Congress could authorize FDA to use other methods, such as voluntary stand- ards or designation of prescription devices, to reg- ulate Class II devices. Other options include leg- islating an additional category of Class II devices with different requirements or reclassifying most existing Class II device types into other classes. Information on risks associated with medical devices is crucial to assessing the 1976 law and its effectiveness in consumer protection. Congress could require FDA to develop better systems for monitoring and providing information on device risks or encourage FDA to selectively apply post- marketing controls to regulate Class II devices. To help manufacturers, especially small ones, through the regulatory process, Congress could encourage FDA to use publicly available infor- mation to down-classify Class III devices as soon as possible. FDA might also act as a broker be- tween small firms with promising devices and clin- ical investigations capable of gathering data to support premarket approval for Class III devices. R&D Policies Related to Medical Devices The present level of private R&D for medical devices appears to be generally adequate. If in- dustrial R&D in medical devices responds to mar- ket opportunities, as it does in other fields, the greater demand for most medical devices because of health insurance would argue that medical devices R&D has been adequately stimulated. From 1974 to 1980, R&D grew at an average annual rate of about 16 percent in medical devices companies, as compared with a rate of about 12 percent in industry as a whole. In 1980, com- pany-sponsored R&D as a percentage of sales was greater in medical devices than in industry as a whole (2.9 percent compared with 1.6 percent). The percentage of company-sponsored R&D devoted to basic research differed only slightly in medical devices firms and in industry as a whole (3.7 percent compared with 4.1 percent). Basic research has long been recognized as sub- ject to underfunding by private companies. As re- search becomes more targeted to development of a commercializable device, however, the case for governmental involvement declines. Federal sup- port has been lower for R&D conducted in medi- cal devices companies than for industrial R&D as a whole. In 1980, the Federal Government funded less than 3 percent of the R&D conducted by med- ical devices firms, compared with 29 percent of that conducted by industry as a whole. Under a new Federal program, the Small Busi- ness Innovation Research (SBIR) program, NIH and other Federal agencies with sizable R&D budgets must set aside a small percentage for R&D awards to small businesses. Although NIH funds for the SBIR program may come at least partly from funds that would otherwise have gone to basic research and nonprofit institutions, the redistributional implications of the program are not yet clear. The program's solicitation and selec- tion methods merit attention as the funds devoted to this effort increase. The Orphan Drug Act of 1983 (Public Law 97- 414) charges the Federal Government to identify and promote orphan products, including both drugs and medical devices. Devices that are very valuable to potential users, especially in relation Ch. 1—Introduction and Summary © 11 to their cost, and that are so costly that it would be unreasonable or inequitable to expect poten- tial users to pay a price sufficient to cover pro- duction costs, are by definition worthy of sup- port. However, it is difficult to distinguish between such orphan devices and devices that lack a suf- ficient market because they are not worthwhile. Neither the Orphan Drug Act nor regulations have provided sound criteria for identifying or- phan devices. By spreading payment across many people, third-party payment may render previ- ous orphan devices and services affordable. Medi- care coverage of dialysis for end-stage renal dis- ease is an example. Expensive devices are usually covered by health insurance, and many of those not covered, including preventive and rehabil- itative devices, may have a large enough market to permit sale at a sufficiently low price. But the problem of orphan devices may grow as third par- ties develop increasingly restrictive payment policies. The Orphan Drug Act makes available to or- phan drugs certain benefits (e.g., grants and con- tracts for clinical testing) that are not available to devices. It appears premature to extend the benefits of the Orphan Drug Act to devices until criteria are developed to distinguish orphan de- vices from those that are not worth their costs. However, an option would be for Congress to mandate that the Department of Health and Human Services develop criteria and methods for identi- fying orphan devices. Regulation of the Providers of Medical Devices Federal regulation of the providers of medical devices applies mainly to facilities, such as hos- pitals, but affects physicians indirectly. Such reg- ulation has been undertaken to promote good quality medical care, to control rising costs by evaluating technology adoption and use, and to ensure access to care, including medical devices. As a condition of receiving funds from Medi- care, hospitals have periodically had to review the medical necessity of admissions, extended stays, 12 e Federal Policies and the Medical Devices Industry and professional services. The reviews performed by Professional Standards Review Organizations (PSROs) focused more on reducing overutiliza- tion of inpatient care and on containing costs than on reducing underuse or improving overall quality of care. The emphasis of PSRO review was con- sistent with the incentives of Medicare's cost-based reimbursement system, which encouraged admis- sions and days and use of technologies even if there were few benefits. The PSRO review pro- gram often led to reductions in admissions and lengths of stay, but when the costs of the program are taken into account, it is not clear that it saved Medicare costs. Under Medicare's new DRG hospital payment system, hospitals continue to have financial in- centives to increase admissions, but they also have incentives to reduce lengths of stay and technol- ogy use for inpatients. In order to be paid by Medicare, participating hospitals are required to contract by November 15, 1984, with utilization and quality control peer review organizations (PROs), which will monitor hospital admissions, lengths of stay, and use of technologies. The focus of the PRO review program has changed from that of the PSRO program to reflect the incen- tives of the new payment system. Like PSROs, PROs will review hospital admissions for overuse. In addition, however, PROs must specifically monitor cardiac pacemaker implantations and reimplantations for possible overuse. PROs will also be more concerned than PSROs were with reviewing short lengths of stay and eventually with underuse of ancillary services. Medical devices have been most directly regu- lated through provider regulation by the State certificate-of-need (CON) laws passed in response to the National Health Planning and Resources Development Act of 1974 (Public Law 93-641). These regulations sought to reduce expensive duplication of technology and to ensure access to facilities. By 1983, all States except one (Louisiana) had passed CON laws, but only 23 were in com- pliance with Federal requirements in 1984. Because of uncertainty about the future of the Federal health planning program, the current continuing resolution stipulates that noncomplying States are not to be penalized. Photo credit: U.S. Veterans Administration The VA Prosthetics Center was involved in developing most of the prosthetic limbs and fitting techniques used today. Institutions such as hospitals, nursing homes, kidney disease treatment centers, and ambulatory surgical centers are required to obtain a CON from a State or State planning agency for capital expenditures that exceed a minimum threshold, substantially change bed capacity, or substantially change services. Medical research institutions and health maintenance organizations (HMOs) are given special consideration. Although State laws may cover investments in other locations, only nine States cover equipment purchases for phy- sicians’ offices. Few devices have been expensive enough to meet the threshold for CON review, which is now $600,000 for capital expenditures, $250,000 for annual operating costs from a change in services, and $400,000 for major medical equip- ment. Under the higher limits that have been pro- posed, fewer devices would come under review. Ch. 1—Introduction and Summary e 13 Evidence on the effect of CON laws on the adoption of medical devices has been inconclu- sive. Early studies indicated that numbers of hos- pital beds fell, but investment and assets per bed, which relate to devices, rose. This result is con- sistent with the CON emphasis on bed supply and the high thresholds for review. There is no indica- tion that CON has controlled medical costs. This finding is not surprising, because a CON agency has no limit on the annual capital expenditures that it may approve and does not consider oper- ating costs, total costs, or use of devices and other technologies. The program was also charged with often-conflicting goals of controlling cost and assuring access, and relied on consensus among decisionmakers with different interests. It is pos- sible, however, that CON procedures may have deterred applications and purchases. The different incentives for hospitals under DRG payment have implications for CON laws. Some of the change depends on how capital ex- penses are handled under the DRG system. Under DRG payment, hospitals themselves may increas- ingly have financial incentives to adopt cost- reducing devices and to examine carefully cost- raising ones. And DRG payment has strengthened the incentive for providers to locate and use equip- ment and facilities outside of the more constrained inpatient setting in such sites as ambulatory diag- nostic centers or physician offices. Several approaches could be taken to deal with the shortcomings of the CON process. Congress could expand the scope of CON regulation to cover purchases of equipment in all locations, or it could place a limit on the annual level of capi- tal expenditures that CON agencies could ap- prove. Alternatively, Congress could eliminate the CON requirement from the National Health Plan- ning Act. Veterans Administration Policies Regarding Medical Devices With 172 medical centers, an annual budget of about $1.3 billion for equipment and supplies, and an R&D budget of almost $160 million, the VA has the potential to exert substantial influence in the market for medical devices, especially the mar- ket for rehabilitative devices. Rehabilitation R&D in the VA is intended to improve the quality of life and to further the in- dependence of physically disabled veterans. The program has stressed developing practical devices and increasing the availability of new devices on the market, especially in prosthetics, sensory aids, and devices related to spinal cord injuries. In the past, the VA Prosthetics Center was involved in developing most of the prosthetic limbs and fit- ting techniques used today and in demonstrating uses of electric wheelchairs, which were then adopted by manufacturers. In recent years, fund- ing has shifted toward intramural projects, such as rehabilitation R&D centers, which are affiliated with leading engineering schools. Adjusted for in- flation, VA funds committed to R&D in rehabil- itative devices have been stable or declining. Responsibility for testing and evaluating med- ical devices is divided among several VA organiza- tional units. Despite the opportunity that the VA system presents to test devices under actual con- ditions of use, problems of coordination among units and of adherence to evaluation protocols have hampered field testing of rehabilitative de- vices at VA medical centers. The Testing and Evaluation Staff in Hines, IL, is responsible for testing nonrehabilitative devices, mainly standard stock items and smaller medical equipment. These evaluations, which are aimed at validating manufacturers’ claims, consist mainly of consumer research efforts. Although VA reg- ulations prohibit explicit comparison of different products, some evaluations of classes of devices have been attempted. These evaluations are used by purchasers of devices inside and outside of the VA system. Through the VA Marketing Center in Hines, which manages and negotiates the VA's national purchasing contracts, the VA has a substantial position in the markets for medical equipment and supplies. Procurement by the VA Marketing Cen- ter has accounted for 5 to 10 percent of the na- tional sales of X-ray, nuclear diagnostic, hemo- dialysis, and patient monitoring equipment. And the VA has enhanced its market leverage by con- 14 e Federal Policies and the Medical Devices Industry tracting for the U.S. Public Health Service, the Department of Defense, and other Government agencies. The VA's market power has allowed the VA to obtain favorable prices on medical supplies through its centralized procurement channels. VA medical centers purchase about 34 percent of their supplies through centralized procurement programs run by the VA or the General Services Administration. However, the medical centers have increasingly made purchases on the open market rather than through central supply chan- nels, their open market purchases having risen from 10 percent of total purchases in the early 1960s to 39 percent in 1982. The VA medical centers’ reduced use of central purchasing prevents the VA from taking advantage of lower prices available through greater device standardization and volume purchases. The patterns of adoption and use of devices by the VA health system are conflicting. Some types of major medical equipment, such as CT scanners, may have been adopted by the VA less than war- ranted because of political pressures to contain costs. On the other hand, by statute, the provi- sion of prosthetic devices to eligible veterans is unlimited. The VA's plan to set the budgets of medical centers on the basis of DRGs may dis- tribute funds more rationally. This DRG system bears monitoring as it is implemented for issues of quality assurance and treatment of capital ex- penses. Congressional options to improve VA policies towards medical devices could focus on specific areas, such as increasing research for longer term development of rehabilitative devices and expand- ing field testing of rehabilitative devices. Congress could also require the VA to move in the direc- tion of undertaking more comparative evaluations of devices and increasing centralized procurement to take advantage of lower prices. Conclusions Since the purpose of the Medical Device Amend- ments of 1976 is to protect public health and safety, assessment of the law and potential changes in the act or its implementation cannot proceed without systematic information on the hazards associated with device use. Such information is now lacking. Available evidence indicates that the medical devices industry has not been system- atically affected by regulation of marketing by FDA, insofar as companies have continued to be profitable and innovative and to enter the field. However, small manufacturers of contact lenses have had particular problems. The medical devices industry has responded to incentives in the market, especially those from payment policies. As a result, the market has gen- erally rewarded attention to technological sophis- tication but not to price or cost-consciousness and has fostered the development of devices used in acute care rather than in prevention and rehabil- itation. Medicare's new method of paying hospi- tals on the basis of DRGs has the potential for cost containment and efficiency by providing in- centives for providers, and hence manufacturers, to become more cost conscious. At the same time, Medicare's DRG payment system raises important concerns: assurance of quality of care when providers have a financial incentive to minimize the use of technologies in- cluding devices, and possible inefficiencies if de- vices are purchased and used in locations less financially constrained than hospitals. The appro- priate role of the CON program is tied to how capital expenses are handled under the DRG pay- ment system. In any case, issues of access to devices for low-income and sparsely populated areas will remain. And as health insurance cov- erage and payment become more constrained, the concept of orphan devices may require more precise definition. The VA has the potential to use its leverage in the market, especially for rehabil- itative devices, to channel development and com- mercialization into orphan devices with substan- tial social need and worth. 2. Characteristics of the Medical Devices Industry INTRODUCTION In recent decades, the industry that manufac- tures medical devices has experienced continuous growth and change. As increased health insurance coverage has expanded purchasing power for medical care, the market for medical devices has grown correspondingly. Growth has occurred not only in the number of companies and employees working in the field, but also in the range of prod- ucts developed and marketed. Throughout all fac- ets of medical care—from diagnostic imaging and surgery to dentistry and optometry—devices un- known a generation or even a decade ago are now part of routine practice. This chapter presents the most notable features of the medical devices industry. Besides the dy- namic nature of the field, several themes emerge. One is great diversity, both in the medical devices that are marketed and in the companies that make them. Underlying the diversity in products is the high level of innovation. Another theme is that, more than in many other U.S. industries, small firms are particularly important in developing and producing medical devices. U.S. medical devices appear to be quite competitive internationally. Despite the diversity in companies and products, however, the concentration of production in med- ical devices is about the same as it is in a typical industry, i.e., a relatively small number of com- panies account for a sizable share of the market. GROWTH IN THE MEDICAL DEVICES INDUSTRY During the past 25 years, sales (value of ship- ments) of products in the five Standard Industrial Classification (SIC) codes representing medical devices have grown from less than $1 billion to more than $17 billion, an annual increase of more than 12 percent (table 1). The growth has been enormous, even when expressed in real dollars, which are intended to take account of price changes? (table 2). By 1982, sales in real dollars had reached six times the 1958 level, having risen at an aver- age annual rate of 8 percent. Growth in sales appears to have accelerated after 1963, a period which coincided with the early years after implementation of the Medicare and Like most price indexes, those of the Department of Commerce measure annual price changes in a market basket of devices that were specified in 1972 (369). A common problem with such indexes is their inability to take into account price changes associated with the introduction of new products and with changes in product quality. This problem is particularly acute for medical devices, which have experienced constant and dramatic change. Medicaid programs in 1966. From 1966 to 1982, total U.S. expenditures on personal health care in real dollars grew at an average annual rate of 5 percent, and those of the Medicare program alone at 18.5 percent. Although the start of Medicare and Medicaid was the most notable change, both private and public third parties have accounted for an increas- ing share of the growing expenditures on personal health care—from 35 percent in 1950 (12 percent private, 12 percent State and local, 10 percent Fed- eral) to 51 percent in 1966 (25 percent private, 12 percent State and local, 13 percent Federal) and 69 percent in 1982 (28 percent private, 11 percent State and local, 29 percent Federal) (128). Al- though the exact relationship has not been doc- umented, growth in health care expenditures ex- panded the market for products such as medical devices that are used in the course of delivering that care (see ch. 3). 17 Table 1.—Current Dollar Value of Shipments of Medical Devices by SIC Code, Selected Years 1958-832 Current dollar value of shipments (in millions) Annual percentage changeb X-ray and Surgical Surgical Dental electro- and appliances equipment X-ray and Surgical Surgical Dental medical medical and and Ophthalmic electro- and appliances equipment equipment instruments supplies supplies goods medical medical and and Ophthalmic Year (SIC 3693) (SIC 3841) (SIC 3842) (SIC 3843) (SIC 3851) Total equipment instruments supplies supplies goods Total 1983¢.... $5,500 $4,590 $6,140 $1,180 NAd $17,410e 21% 12% 9% 7% _— 13%e 1982. .... 4,557 4,114 5,642 1,107 $1,358 16,778 42 30 19 -16 8 23 1981..... 3,203 3,158 4,734 1,314 1,263 13,672 27 17 23 5 4 18 1980. .... 2,527 2,697 3,861 1,252 1,212 11,549 10 14 14 17 8 13 1977. .... 1,885 1,833 2,597 787 972 8,074 34 14 12 14 11 16 1972..... 444 962 1,454 409 568 3,837 14 15 12 13 6 12 1967... .. 233 475 838 221 426 2,193 13 14 9 11 12 11 1963. .... 144 284 597 148 273 1,446 9 17 5 5 7 8 1958. .... 95 130 462 116 194 997 oe — — — — — For a listing of products in the Standard Industrial Classification (SIC) codes used, see table 7. For inconsecutive years, the compound annual growth rate, the annual rate of growth that makes the present value compound forward to equal a specified future value, was calculated. %A = [(FVIPV)UN — 1] 100, where %A = compound annual growth rate FV future value (the value at the end of N compounding periods) PV present value N total number of compounding periods CPreliminary estimates. NA indicates information not available. Total does not include shipments of ophthalmic goods. SOURCES: U.S. Department of Commerce, Bureau of Industrial Economics, Capital, Energy, and Productivity Studies Division, Washington, DC, unpublished data, January 1984; P. Marcus, U.S. Department of Commerce, Washington, DC, personal communication, 0B la roa) Department of Commerce, Bureau of the Census, 1982 Census of Manufactures, Preliminary Report Industry Series, MC82-1-36F-3(P), -1-38B- MC82-1-38B-1(P), MC82-1-38B-2(P), MC82-1-38B-3(P), M ), 1984; and E. Arakaki, U.S. Department of Commerce, Washington, DC, personal communication, August 1984. Auysnpuj s8o1r8Q [B2IPO BY} PUB S8101j0d [BI9Pa- o GI Table 2.—Real (1972) Dollar Value of Shipments of Medical Devices by SIC Code? Selected Years 1958-83 Real (1972) dollar value of shipments (in millions) Annual percentage changeP X-ray and Surgical Surgical Dental electro- and appliances equipment X-ray and Surgical Surgical Dental medical medical and and Ophthalmic electro- and appliances equipment equipment instruments supplies supplies goods medical medical and and Ophthalmic Year (SIC 3693) (SIC 3841) (SIC 3842) (SIC 3843) (SIC 3851) Total equipment instruments supplies supplies goods Total 1983c .... $2,145 $2,050 $2,975 $540 NAd $7,710e 15% 7% 7% 2% — 9%e 1982... .. 1,858 1,915 2,790 528 $757 7,848 35 21 19 -20 8 18 1981..... 1,374 1,587 2,337 659 704 6,661 14 6 16 -4 -4 9 1980. .... 1,210 1,494 2,007 685 735 6,131 -1.7 5 7 7 1 4 1977... .. 1,274 1,273 1,649 564 707 5,467 23 6 3 7 4 7 1972... .. 444 962 1,454 409 568 3,837 7 11 10 12 3 9 1967... .. 311 568 920 234 479 2,512 9 11 7 10 11 9 1963... .. 217 377 705 160 312 1,771 8 15 5 4 6 7 1958... .. 150 184 549 130 231 1,244 — — — —_ — — aFor a listing of products in the SIC categories used, see table 7. bFor inconsecutive years, the compound annual growth rate, the annual rate of growth that makes the present value compound forward to equal a specified future value, was calculated. %a = [(FV/PV)N — 1] 100, where %A = compound annual growth rate FV future value (the value at the end of N compounding periods) PV present value N total number of compounding periods CPreliminary estimates. dNA indicates information not available. eTotal does not include shipments of ophthalmic goods. SOURCES: U.S. Department of Commerce, Bureau of Industrial Economics, Capital, Energy, and Productivity Studies Division, Washington, DC, unpublished data, January 1984; P. Marcus, U.S. Department of Commerce, Washington, DC, personal communication, January 1984; M. Pavliscak, U.S. Department of Commerce, Washington, DC, personal communication, June 1984; and E. Arakaki, U.S. Department of Commerce, Washington, DC, personal communication, August 1984. 61 o Ausnpuj s82iAaQ [IIPS BY} JO SO1ISLI8IoBIBYD—C YO 20 e Federal Policies and the Medical Devices Industry All segments of the medical devices industry have benefited from this growth, some more than others (tables 1 and 2). Most medical devices fall into one of five SIC codes of the Department of Commerce: 3693, X-ray, electromedical, and electrotherapeutic equipment; 3841, surgical and medical instruments; 3842, orthopedic, prosthetic, and surgical appliances and supplies; 3843, den- tal equipment and supplies; and 3851, ophthal- mic goods.2 The most comprehensive statistics on the medical devices industry come from the Census of Manufactures, which is conducted by the Bureau of the Census in the Department of Commerce. The data relate to domestic production by U.S. and foreign companies oper- ating in the United States. A complete census is conducted every 5 years and an Annual Survey of a sample in intervening years. Prod- ucts are categorized by Standard Industrial Classification (SIC) codes. Establishments are assigned to SIC “industries” on the basis of their primary line of business. A 1980 sample of 1,891 manufacturing establishments registered with the Bureau of Medical Devices in the Food and Drug Administration (FDA) fell into 162 SIC codes: 47 percent into the 5 major medical devices codes, which included an average of 177 establishments per code; 37 percent into 25 other SIC codes, each with 10 or more establishments; and 16 percent into 132 other SIC codes, each with fewer than 10 establishments (393). It can therefore be inferred that the establishments in the five medi- cal devices codes account for a greater volume of medical devices production than those in other codes. Nevertheless, data by estab- lishment from the five medical devices SIC codes exclude some establishments and perhaps some devices of multiproduct establish- ments whose primary products fall into other categories. In addition, the FDA sample lists 47 establishments in SIC 2831, biologicals (393). Diagnostic substances and other biologicals rep- resent about 45 percent of all shipments in SIC 2831 (363), but the data are not sufficiently detailed to permit separation of these med- ical devices products from other biologics, such as blood and vaccines. SIC data on product shipments, however, include shipments of all medical devices, both those produced by establishments classified in the five medical devices codes and those classified in other codes (393). In both current and real dollars, sales of prod- ucts in SIC codes 3693, 3841, and 3842 are much greater than sales of dental equipment and sup- plies and ophthalmic goods. Not only are sales in these three codes the largest in absolute terms, but they have also experienced the highest rates of increase, especially since 1980. SIC 3842 (sur- gical appliances and supplies), the category with the greatest sales, has had the highest growth rates, followed closely by SIC 3693 (X-ray, elec- tromedical, and electrotherapeutic equipment). The tremendous growth in SIC 3693 from 1972 to 1977 may be somewhat overstated; in 1977, products misclassified in other SIC codes, mainly 3841, were assigned to 3693 (393). Increases in the number of companies (firms) and establishments (plants) have paralleled the in- creases in sales (see table 3). From 1963 to 1982, SIC 3693 (X-ray and electromedical equipment), with annual rates of about 7 and 8 percent respec- tively, experienced the greatest rate of increase in companies and establishments. During this period, the other four SIC codes had annual increases ranging from about 2 to 6 percent. In all five med- ical devices codes, firms entering a field have thus exceeded those exiting. By 1982, employment in the establishments in the SIC medical devices codes had exceeded 200,000, a 68-percent increase over the 129,500 employed in 1972 (see table 4). SIC 3693 (X-ray and electromedical equipment) again had the greatest rates of increase, reflecting the huge growth in production and facilities during the decade. Table 3.—Growth in Medical Device Companies, Establishments, and Employment by SIC Code?, 1963-82 1982 levels (number) 1963-1982 compound annual growth rate Employment SIC industry segment Companies Establishments (thousands) Companies Establishments Employment Total ..........o ill 2,986 3,361 217.5 4.4% 4.0% 5.6% SIC 3693: X-ray and electromedical equipment ............... 205 260 49.2 7.1 8.2 11.5 SIC 3841: Surgical and medical instruments ...... 767 858 57.4 5.9 5.8 7.3 SIC 3842: Surgical appliances and supplies ............. 1,212 1,365 68.6 4.5 3.5 4.8 SIC 3843: Dental equipment and supplies ............. 435 474 15.4 2.6 2.2 3.5 SIC 3851: Ophthalmic goods... 367 404 26.9 3.0 3.0 1.5 aFor a listing of products in the SIC categories used, see table 7. SOURCES: U.S. Department of Commerce, Bureau of the Census, 1963 Census of Manufactures, Industry Series, MC63-1-36E and MC63-1-38A, 1982 Census of Manufac- tures, Preliminary Report Industry Series (Washington, DC: U.S. Government Printing Office, 1966 and 1984). Ch. 2—Characteristics of the Medical Devices Industry e 21 Table 4.—Number of Employees in the Medical Devices Industry by SIC Code?, Selected Years 1958-83 (in thousands) X-ray and Surgical Surgical Dental electro- and appliances equipment medical medical and and Ophthalmic equipment instruments supplies supplies goods Year (SIC 3693) (SIC 3841) (SIC 3842) (SIC 3843) (SIC 3851) Total 19830 ..... 50.5 62.0 71.2 16.2 NAc 199.9d 1982 ...... 49.2 57.4 68.6 15.4 26.9 217.5 1981 ...... 41.5 54.6 64.9 17.4 26.4 204.8 1980 ...... 38.8 51.3 61.8 16.7 29.4 198.0 1977 ...... 30.9 43.2 53.9 16.3 30.0 174.3 1972... .. 12.1 34.5 43.9 12.4 26.6 129.5 1967 ...... 7.9 22.0 35.2 10.2 25.6 100.9 1963 ...... 6.2 15.1 28.3 8.0 20.3 77.9 1958 ...... 53 10.3 24.2 7.2 18.2 65.2 8For a listing of products in the SIC categories used, see table 7. Preliminary estimates. SNA indicates information not available. Total does not include employment in the ophthalmic goods industry. SOURCES: U.S. Department of Commerce, Bureau of the Census, Annual Survey of Manufactures, Statistics for Industry Groups and Industries, for years 1958, 1963, 1967, 1972, 1977, and 1981; U.S. Department of Commerce, Bureau of Industrial Economics, 1984 U.S. Industrial Outlook (Washington, DC: U.S. Government Printing Office, January 1984); and E. Arakaki, Department of Commerce, Washington, DC, personal communication, August 1984. In 1982, about 3,000 companies (firms) with 3,400 establishments (plants) were manufactur- ing products in the five medical devices SIC codes (table 3). Although this information is the most comprehensive and most recent available, it ex- cludes multiproduct establishments with primary products in other codes. Changes in employment may be used as a proxy for changes in numbers of companies and establishments. In 1980, 4,300 establishments were registered with the Food and Drug Administration (FDA) as being engaged in manufacturing medical devices (197). Available information from the Internal Reve- nue Service (IRS) indicates that the profit rates of medical devices companies have exceeded those of many other manufacturing industries (table 5). The IRS category 3845 (optical, medical, and oph- thalmic goods) includes some firms that do not produce medical devices (optical instrument and lenses firms) and excludes some that do (if their principal line of business lies in a different cate- gory). Nevertheless, this category contains sub- stantial numbers of firms whose principal activ- ity is producing medical devices (26). Sales of electrical medical devices may represent a small fraction—perhaps at the most 10 percent—of IRS category 3698 (other electrical equipment) (26). 3As explained in ch. 5, several entities besides medical devices man- ufacturers also register with FDA. Annual profit rates for both of these IRS catego- ries ranged from 10 to 18 percent (26), higher than the 9 to 11 percent in total manufacturing. In 1980, firms in IRS category 3845 (optical, medi- cal, and ophthalmic goods), with 12.7-percent re- turn on assets, were more profitable than firms in similar products such as other electrical equip- ment, chemicals and allied products, and electri- cal and electronic equipment.* By any of these measures—sales, companies, establishments, employment, or profits—the growth of the medical devices industry has far exceeded that of many other industries (table 6). For ex- ample, from 1963 to 1982, the output of the total manufacturing sector grew at an annual rate of 2.7 percent and employment at a 0.5-percent rate. Even chemicals and related products, electrical and electronic equipment, and instruments and related products—sectors with products similar to medical devices—achieved much lower annual increases in output (from 4.3 to 5.6 percent an- nually) and in employment (from 1.4 to 2.9 per- cent annually). According to data from Dun & Bradstreet, returns on assets (in- dicators of profits) for medical devices SIC codes have equaled or exceeded returns on assets in other fields (95). For example, from 1978 to 1980, returns on assets for SIC 3693 (X-ray, electromedi- cal, and electrotherapeutic devices) ranged from 8.8 to 11.4 percent, compared with a range of 9.0 to 9.8 percent for the broader SIC category 36 (electrical and electronic machinery, equipment, and supplies.) 22 e Federal Policies and the Medical Devices Industry Table 5.— Percent Return on Assets? for Medical Devices and Selected Industries by IRS Category, Selected Years 1963-80 Optical, medical Other Chemicals Electrical and ophthalmic electrical Total and allied and electronic goodsP equipmentc manufacturing products equipment Year (IRS 3845) (IRS 3698) (IRS 40) (IRS 17) (IRS 25) 1980. ..... 12.7% 11.0% 10.5% 11.2% 9.6% 1977 ...... 14.5 11.2 10.6 125 10.5 1972...... 13.1 9.6 8.8 11.3 7.7 1967 ...... 17.9 13.6 10.2 12.8 114 1963...... 121 12.9 10.2 14.0 9.5 3Percent return on assets = Total assets Net income (less deficit) + interest paid Net income (less deficit) equals “total receipts less total deductions” less “interest on State and local Government obligations” plus “constructive taxable income from related foreign corporations. he IRS minor industry 3845 (optical, medical and ophthalmic goods) includes firms that would be classified in SIC categories He fo tical instruments and lenses), 384 (surgical, medical e » and dental instruments and supplies), and 385 (ophthalmic goods). S minor industry 3698 (other electrical equipment) includes firms that would be classified in SIC categories 361 (electric transmission and distribution equipment), 362 (electrical industrial apparatus), 364 (electric lighting and wiring equipment), and 369 (miscellaneous electrical machinery, equipment, and supplies). SOURCES: US. Department of the Treasury, Internal Revenue Service, Sourcebook of Statistics of Income, for years 1963, 1967, 1972, 1977, and 1980; Corporation Income Tax Returns, statistics of income, for years 1963, 1967, 1972, 1977, and 1980; A General Description of the Corporation Source Book, publication 647, revised June 1983. Table 6.—Growth in the Output and Employment of Selected Industries, 1963-82 1963-82 compound annual growth rate Industrial sector Output Employment Total manufacturing ...... 2.7% 0.5% Chemicals and allied products ........ 4.3 1.4 Electrical and electronic equipment . .. 5.6 1.5 Instruments and related products ....... 5.6 29 SOURCES: US. Department of Commerce, Bureau of Industrial Economics, 1984 US. Industrial Outlook (Washington, DC: U.S. Government Printing Office, January 1984); and V. Ketterling, U.S. Department of Com- merce, Bureau of Industrial Economics, Washington, DC, personal communication, February 1984. DIVERSITY IN PRODUCTS The devices included in the five major SIC codes illustrate the wide range of products, not only across codes but within each code as well (table 7). SIC 3842 encompasses disposable sup- plies such as surgical drapes and adult diapers as well as wheelchairs and prostheses. And together the different codes include pacemakers, hospital furniture, and materials for dentures. Table 8 presents 1982 sales of selected medical devices to U.S. hospitals. These data are national estimates that IMS America, Ltd., has compiled The Department of Commerce has ranked sev- eral of the medical devices SIC codes in the top 50 codes whose growth in 1984 is predicted to ex- ceed their 1972-81 peak: 3842, orthopedic, pros- thetic, and surgical appliances and supplies, as 9th; 3693, X-ray, electromedical, and electrothera- peutic equipment, as 11th; 3841, surgical and medical instruments, as 13th; 2831, biological products, as 24th; and 3843, dental equipment and supplies, as 47th (369). for OTA from the purchases of a sample of hos- pitals. Because the IMS data include only devices that are purchased frequently enough to permit statistical estimation, many expensive devices that are rarely purchased by individual hospitals, such as computed tomography (CT) scanners, do not appear. Almost half of personal health care expendi- tures in the United States relate to hospital care (128), and hospitals use devices more intensively than other health care settings. Thus, the data in table 8 give some indication of the size of the mar- Ch. 2—Characteristics of the Medical Devices Industry ¢ 23 Table 7.—Products in the Medical Devices Industry by SIC Code? SIC codel/products 3693—X-ray, electromedical, and electrotherapeutic apparatus Irradiation (ionizing radiation) equipment, including X-ray, beta ray, gamma ray, and nuclear (medical, dental, industrial, and scientific) Medical X-ray equipment: Diagnostic Therapeutic Dental X-ray equipment Industrial and scientific X-ray equipment, excluding gamma and beta ray equipment X-ray equipment accessories X-ray tubes (sold separately) Parts for X-ray equipment (sold separately) All other ionizing radiation equipment, including gamma and beta ray equipment, excluding accelerators, cyclotrons, etc. Irradiation (ionizing radiation) equipment, including X- ray, beta ray, gamma ray, and nuclear (medical, dental, industrial, and scientific), n.s.k. Electromedical equipment, including diagnostic, therapeutic, and patient monitoring, but excluding ionizing radiation equipment Diagnostic: Electrocardiograph (ECG) Electroencephalograph (EEG) Electromyograph (EMC) Ultrasonic scanning devices Automated blood and body fluid analyzers Audiological equipment Endoscopic equipment (bronchoscope, cystoscope, proctosigmoidoscope, colonoscope, etc.) Respiratory analysis equipment All other diagnostic equipment Therapeutic: Pacemakers Defibrillators Electrosurgical equipment Diathermy apparatus (short wave and microwave) Dialyzers Ultrasonic therapeutic equipment All other therapeutic equipment Patient monitoring: Intensive care/coronary care units, including component modules such as temperature, blood pressure, and pulse Perinatal monitoring Respiratory monitoring All other patient monitoring equipment Surgical support systems: Heart-lung machines, excluding iron lungs Blood-flow systems All other surgical support systems Parts and accessories for diagnostic, therapeutic, monitoring, and surgical support systems (sold separately) Electromedical equipment, including diagnostic, therapeutic, and patient monitoring, but excluding ionizing radiation equipment, n.s.k. X-ray, electromedical and electrotherapeutic apparatus, n.s.k., typically for establishments with more than 5 employees SIC codel/products X-ray, electromedical and electrotherapeutic apparatus, n.s.k., typically for establishments with less than 5 employees 3841— Surgical and medical instruments and apparatus Surgical instruments, including suture needles, and eye, ear, nose, and throat instruments Orthopedic instruments, such as bone drills and bone plates, excluding eye, ear, nose, and throat instruments Diagnostic apparatus: Metabolism and blood pressure Optical diagnostic Other Syringes: Other than hypodermic Hypodermic: Uniquely designed for prefilling Other Hypodermic needles Anesthesia apparatus, instruments, and parts Oxygen tents Veterinary instruments Blood transfusion and intravenous equipment Blood donor kits Mechanical therapy appliances and parts thereof Other surgical and medical instruments Surgical and medical instruments, n.sk. Hospital furniture, excluding beds and chairs Operating room furniture, including tables, cases, cabinets, etc. Patient room furniture, including cabinets, overbed tables, desks, dressers, etc, but excluding beds and chairs Other hospital furniture, excluding operating and patient room furniture, beds, and instruments, but including cases, tables, bassinets, chart racks, backrests, etc. Hospital furniture, n.s.k. Surgical and medical instruments, n.s.k. typically for establishments with 5 employees or more Surgical and medical instruments, n.s.k., typically for establishments with less than 5 employees 3842—Surgical appliances and supplies Surgical, orthopedic, and prosthetic appliances and supplies Orthopedic appliances (braces), including parts Sterilizers (hospital and surgical), excluding dental sterilizers Surgical dressings: Bandages, elastic Bandages, other, including muslin, plaster of paris, etc. but excluding self-adhering bandages Adhesive plaster, medicated and nonmedicated, including self-adhering bandages Gauze (absorbent and packing) Cotton, including cotton balls (sterile and nonsterile) Other surgical dressings, including sponges, compresses, pads, etc. Disposable surgical drapes, including O/B and O/R packs Disposable incontinent pads, bed pads, and adult diapers Sterile surgical sutures: Absorbable Nonabsorbable Artificial limbs (prosthetic), including parts Elastic stockings 24 e Federal Policies and the Medical Devices Industry Table 7.—Products in the Medical Devices Industry by SIC Code—continued SIC codel/products SIC code/products Elastic braces, suspensories, and other elastic supports Arch supports and other foot appliances Corn remover pads, bunion pads, etc. Breathing devices, excluding anesthetic apparatus but including incubators, respirators, resuscitators, inhalators, etc. Surgical corsets Crutches, canes, and other walking assistance devices Splints and trusses Wheel chairs Other surgical orthopedic, and prosthetic appliances and supplies Surgical, orthopedic, and prosthetic appliances and supplies, n.s.k. Personal industrial safety devices Respiratory protection equipment, including gas masks, abrasive masks, canister masks, etc. Eye and face protection devices, including face shields, hoods, and welding helmets and masks, but excluding industrial goggles and eye protectors Protective clothing, except shoes First aid snake bite and burn kits, both household and industrial types Other personal safety devices Personal industrial safety devices, n.s.k. Hearing aids, electronic: Hearing aids, electronic Surgical appliances and supplies, n.sk., typically for establishments with 5 employees or more Surgical appliances and supplies, n.sk., typically for establishments with less than 5 employees 3843— Dental equipment and supplies Dental metals: Precious Nonprecious Dental alloys for amalgams Teeth, excluding dentures: Porcelain Other, including resinous and plastic Denture-base materials Dental chairs Instrument delivery systems (dental units) Dental hand pieces Other dental professional equipment, except X-ray Dental laboratory equipment, including furnaces, casting machines, lathes, benches, polishing units, flasks, blowpipes, presses, etc. Dental hand instruments (forceps and pliers, brosches, cutting instruments, etc.) Burs, diamond points, abrasive points, wheels, disks, and similar tools for use with hand pieces Dental cements and other non-metallic filling materials Waxes, dental gypsums, and other consumable supplies Other dental products including sterilizers, but excluding X- ray equipment Dental equipment and supplies, n.sk., typically for establishments with 5 employees or more Dental equipment and supplies, n.sk., typically for establishments with less than 5 employees 3851— Ophthalmic goods Ophthalmic fronts and temples Fronts, finished (with or without decoration), and temples: Gold filled fronts (full rimmed, semirimless, or rimless) Aluminum and other base metal fronts Plastic fronts Combination fronts Temples, all types Ophthalmic fronts and temples, n.s.k. Glass ophthalmic focus lenses Single vision lenses (ground and polished and moulded blanks) Multifocal lenses: Bifocals Trifocals and double segments Glass ophthalmic focus lenses, n.s.k. Plastic ophthalmic focus lenses Single vision lenses Multifocal lenses Plastic ophthalmic focus lenses, n.s.k. Contact lenses Conventional (hard) Soft Contact lenses, n.s.k. Other ophthalmic goods, nec. Centers, oxfords, parts, trims, etc. Ophthalmic spectacles and eyeglasses (frames and mountings of all types when sold with corrective lenses inserted, with or without decoration) Industrial goggles, eye protectors, welding circles and plates, mountings, and parts Sun or glare glasses and sungoggles, ready-made Nonfocus fashion tinted lenses, plastic and glass Other ophthalmic goods and accessories (sunglass frames, single readers and magnifiers, holders, gas mask inserts, etc.) All other ophthalmic goods, n.s.k. Ophthalmic goods, n.s.k., typically for establishments with 5 employees or more Ophthalmic goods, n.s.k., typically for establishments with less than 5 employees @n.e.c.—Not elsewhere classified. n.s.k.—Not specified in kind. SOURCE: U.S. Department of Commerce, Bureau of the Census, Annual Survey of Manufactures, Statistics for Industry Groups and Industries, 1977. Ch. 2—Characteristics of the Medical Devices Industry ¢ 25 Table 8.—Sales of Selected Medical Devices to Hospitals by SIC Code, 1982 Sales to Sales to hospitals hospitals (thousands (thousands SIC code/product of dollars) SIC code/product of dollars) X-ray and electromedical equipment Bandages, dressings and elastic ........ 172,303 (SIC 3693) Orthopedic supplies ................... 302,283 X-ray supplies .............n $ 777,366 Parenteral supplies .................... 701,106 Radiological catheters and Urological products ................... 198,970 guide wire... 135,878 Sterilizer supplies ..................... 88,846 Pacemakers and other Cast room supplies ................... 39,836 cardiovascular products. ............. 499,999 Disposable kits and trays .............. 258,317 Electrosurgical supplies ............... 48,552 Respiratory therapy. ................... 245,890 Surgical and medical instruments (SIC 3841) Garments, textiles, and gloves .......... 592,254 Surgeons’ needles .................... 4,310 Blood collection supplies .............. 57,845 Ophthalmic goods (SIC 3851) THErmMOMELErS «ovo oreeee eee 31,426 Ophthalmic-related products............ 83,649 Surgical instruments ........... 294,284 Syringes and needles .................. 331,054 Other Catheters, tubes, and allied products .. .. 235,445 Solutions «oi 872,985 Diagnostic instruments ................ 69,549 Medical supplies....................t 420,702 : ; ; Chemicals and soaps. ................. 153,946 Surgical appliances and supplies (SIC 3592) peg as Paper produots ..................o... 113738 Ostomy products. ........ovvvnenene... 13,842 GASES otitis 109,933 Surgical packs and parts ............... 174,123 Underpads ....... AREER 55,259 Maternity products .................... 26,869 Identification supplies ................. 31,517 Dialysis supplies...................... 97,677 Elastic goods... 24,932 Cardiopulmonary supplies. ............. 71,176 Rubber goods .............ocoeovenens 7,281 SPONGES «vv 174,768 Total. ooo $7,804,545 SOURCE: IMS America, Ltd., Rockville, MD, unpublished data, 1983. ket for different devices. The highest sales to hos- pitals are of disposable or nondurable items, such as X-ray supplies and garments, textiles, and gloves. For many of the devices with high sales volumes, hospitals account for only a portion of the overall market. For example, parenteral sup- plies (for feeding through the bloodstream rather than the alimentary canal) are increasingly used in home health care (see ch. 3) and X-ray supplies are also purchased by independent diagnostic centers and private offices. Nondurable products are even more prominent among the medical devices in a physician's office. Table 9 lists the medical devices in an office of two internists practicing in an urban setting. Al- though the office contains basic medical furniture and equipment, most of the products are disposed of after one use. CHARACTERISTICS OF MEDICAL DEVICES MANUFACTURERS As indicated by table 3, the number of device companies is almost as large as the number of establishments, with an average of 1.13 establish- ments per company. This relationship implies that the mode in the medical devices industry is a com- pany with one plant, although larger companies 25-406 O - 84 - 3 are likely to have multiple plants. This pattern appears to be similiar to that in other industries. For industries in which the four leading firms ac- counted for between 40 and 64 percent of mar- ket sales, a situation similar to that in the medi- cal devices industry, the four leaders in 1963 26 ¢ Federal Policies and the Medical Devices Industry Table 9.—Medical Devices in an Internist’s Office Medical fixtures: (examining tables and other fixtures used for medical purposes) Examination rooms (2) 2 exam tables with stirrups and storage drawers 2 scales 1 treatment cabinet (large) 1 instrument cabinet (small) 1 eyechart Laboratory 1 X-ray view box 1 test tube rack 1 sedimentation tube rack Medical office supplies: 1 hanging medical record cabinet (7 tiers) Manila chart folders Printed forms for charts Prescription blanks Color-coded medical record stickers Diagnostic supplies: Cover slides Urinalysis plastic cups Wipes for urinalysis clean catch Table paper Drapes Paper tape Bili lab stix (dip-urinalysis) KY jelly Pregnancy test kit (urinary chorionic gonadotrophins (UCG)-Beta slide) Sedimentation tubes, cotton plug Stains (Gran’s iodine-safranin, etc.) Throat culture plates (oxblood 5%) Discs for throat cultures (Taxo A) Uricults Hemoccult slides (single and triple) Electrocardiograph (EKG)-mounting paper, electro pads & electrode cream Sani vaginal specs size (S) Sani vaginal specs size (M) Anoscopes Cards for tuberculosis test Sclavotest purified protein derivative (PPD) tuberculosis test Patient gowns (cloth) Cloth tape measures Thermometers Gonococcus culture plates Blood drawing tubes Alcohol wipes Sterile swabs Swabs Baggies Cervi scrapes Fixative spray for Pap slides Slides (wet mount for Pap) Cardboard containers for Pap slides Culturettes Gloves (med Tru-touch) Request slips for tests Therapeutic supplies: Gauzes Syringes Peroxide Alcohol Betadine scrub Cidex 7 (long life) Drug samples Bandaids Diagnostic equipment: Examination rooms (2) 2 wall model Baumanometer blood pressure instruments (3 cuffs) 1 EKG machine 2 Burton exam lamps 2 otoscope/ophthalmoscope desk units Laboratory 1 centrifuge (provided on load by lab) 1 microscope 1 incubator Therapeutic equipment: Instruments (minor surgical--i.e,, scissors, scalpels, tweezers, etc.) SOURCE: R. Berenson, Washington, DC, personal communication, January 1984. averaged 4.7 establishments per company and the next four, 2.4 establishments per company; but the remaining firms averaged only 1.08 establishments per company (274). In 1977, medical devices establishments aver- aged 54 employees, about the same as the 53 employees per establishment for all manufactur- ing (362). Within the medical devices field, SIC 3693 (X-ray and electromedical equipment) had the largest average size establishment with 127 employees, and SIC 3843 (dental equipment) had the smallest with 30 employees (table 10). Despite the growth that has occurred in medi- cal devices in recent years, there have not been major increases in the average size of an estab- lishment. In fact, for all of the major medical devices SIC codes except X-ray and electromedi- cal equipment and dental equipment, average employee size fell from 1972 to 1977; for SIC 3693 (X-ray and electromedical equipment), it rose from 116 to 127 employees per establishment, and for SIC 3843 (dental equipment), it rose from 29 to 30 employees per establishment (362). From these statistics, one may infer that, with the pos- sible exception of X-ray and electromedical equip- Ch. 2— Characteristics of the Medical Devices Industry ¢ 27 Table 10.—Size of Employment in Medical Devices Establishments by SIC Code, 1977 Number of establishments by employee size Percentage of all establishments average number by employee size of employees SIC industry segment 1-19 20-99 100-499 =500 1-19 20-99 100-499 =500 per establishment SIC 3693: X-ray and electro- medical equipment ......... 117 55 55 16 48% 23% 23% 7% 127 SIC 3841: Surgical and medical instruments........ 412 147 72 19 63 23 11 3 66 SIC 3842: Surgical appliances and supplies .............. 832 213 86 22 72 18 7 2 46 SIC 3843: Dental equipment and supplies .............. 431 85 30 4 78 15 5 1 30 SIC 3851: Ophthalmic goods .. 479 98 50 7 76 15 8 1 47 Total «o.oo oe. 2,2T1 598 293 68 70% 19% 9% 2% 54 SOURCE: U.S. Department of Commerce, Bureau of the Census, 1977 Census of Manufactures, Industry Series, MC 77-1-38B and MC 77-I-36F (Washington, DC: U.S. Government Printing Office, June 1980). ment, growth has occurred through increases in the numbers rather than in the size of establishments. Although small establishments dominate in number, they account for a much smaller frac- tion of total shipments in each SIC code (table 11), and these patterns have been extremely stable since 1963 (393). The extremes are again rep- resented by X-ray and electromedical equipment and dental equipment. Among manufacturers of X-ray and electromedical equipment in 1977, establishments with fewer than 50 employees sold only 5 percent of all shipments, but those with 250 or more employees sold 71 percent of all ship- ments. In the dental equipment field, establish- ments with fewer than 50 employees sold 21 per- cent and those with 250 or more employees sold 46 percent of all shipments (393). There is some evidence that larger medical devices establishments have higher profit rates than smaller ones. One indicator of profits is the difference between the cost of manufacturing a product and the price for which it is sold. Price- Table 11.—Market Share of Value of Medical Devices Shipments by Establishment Size, 1977, 1972, and 1963 Percentage of market share Total of establishments by employee size : number SIC industry segment of establishments 1-49 50-99 100-249 >250 SIC 3693: X-ray and electromedical equipment 1977 243 5% 5% 19% 71% 1972 104 7 4 20 69 1963 58 6 11 23 60 SIC 3841: Surgical and medical instruments 1977 650 12 9 17 62 1972 506 1 11 21 57 1963 294 15 11 24 39 SIC 3842: Surgical appliances and supplies 1977 1,153 13 8 16 63 1972 873 12 6 13 69 1963 704 12 8 1 69 SIC 3843: Dental equipment and supplies 1977 550 21 8 25 46 1972 429 22 14 24 39 1963 316 23 20 21 36 SIC 3851: Ophthalmic goods 1977 634 15 5 17 63 1972 494 12 7 17 64 1963 229 9 14 12 65 SOURCES: US. Department of Commerce, Bureau of the Census, Census of Manufactures, Industry Series, for years 1963, 1972, and 1977, as cited in Arthur Young & Co., A Profile of the Medical Technology Industry and Governmental Policies, final report, vol. 1, June 30, 1981. 28 e Federal Policies and the Medical Devices Industry cost margins have been calculated for medical devices establishments with data from the Census of Manufactures (table 12). According to these 1977 data, price-cost margins were highest for the largest establishments. In only two of the five codes, however, did the smallest sized establish- ments have the lowest margins. A serious problem with these figures is that they overstate profits be- cause they exclude costs such as research and de- velopment, advertising, and depreciation (18). Small companies in the medical devices field have a greater share of industry output than in manufacturing generally (26). Companies with one establishment account for 21 percent of all sales of medical instruments and supplies and 31 percent of optical and ophthalmic goods, but only 16 percent of all manufacturing.® Companies with SThese data are compiled on the basis of companies rather than establishments. The category optical and ophthalmic goods includes products such as telescopes and other optical equipment and hence is broader than medical devices (26). fewer than 250 employees account for 25 percent of all sales of medical instruments and supplies and 32 percent of optical and ophthalmic goods as compared with 18 percent of all manufacturing. The role of small firms in medical instruments and supplies is comparable to that of those in elec- tronic components in terms of number of estab- lishments or total receipts. If firm size is defined by number of employees, small medical instru- ment and supply firms with fewer than 250 em- ployees account for a larger share of sales than firms of a similar size in the electronic components industry. Table 12.—Price-Cost Margins® of Medical Devices Establishments by Employee Size, 1977 Margins of establishments by employee size SIC industry segment Total 1-49 50-99 100-249 > 250 SIC 3693: X-ray and electromedical equipment LL... 0.406 0.374 0.275 0.398 0.422 SIC 3841: Surgical and medical instruments ........ 0.394 0.326 0.360 0.368 0.420 SIC 3842: Surgical appliances and supplies ......... 0.374 0.307 0.322 0.355 0.400 SIC 3843: Dental equipment and supplies .......... 0.325 0.283 0.360 0.274 0.366 SIC 3851: Ophthalmic goods ..................... 0.352 0.350 0.297 0.351 0.357 @Price-cost margins are calculated from Bureau of the Census data as follows: Value added -— Payroll Value of shipments Price-cost margin = “Value added” is the value of shipments minus materials, supplies, energy and certain other input costs. It is defined by the Census on an establishment basis. Price-cost margins are just one measure 0 profitability; each different measure has advantages as well as disadvantages. Limitations of the price-cost margins are: 1) the margins are overstated proxies of profitability since the Census does not provide directly comparable estimates of non-plant costs such as advertisting, central office costs, R&D, and plant depreciation, and 2) the margins are conceptually inadequate because they fail to account for the industry's capital intensity. SOURCE: US. Department of Commerce, Bureau of the Census, 1977 Census of Manufactures, Industry Series, as cited in Arthur Young & Co., A Profile of the Medical Technology Industry and Governmental Policies, final report, vol. 1, Washington, DC, June 30, 1981. CONCENTRATION IN THE MEDICAL DEVICES INDUSTRY The extent to which sales are concentrated among a few companies is a measure of the com- petitiveness of an industry. Despite the large num- ber of companies, especially small ones, concen- tration in the five medical devices SIC codes is similar to that in other manufacturing industries. In 1977, the four leading firms accounted for 32 to 45 percent of the sales in the medical devices SIC codes (table 13). By comparison, in 43 per- cent of all U.S. manufacturing industries during 1972, the four leading firms had 40 percent or more of the total market (274). In the five medi- cal devices codes, the share of the four or eight leading firms has been continually declining since Ch. 2—Characteristics of the Medical Devices Industry e 29 Table 13.—Market Share of Value of Medical Devices Shipments by Leading Companies, 1977 and 1963 Percentage of market share Total number of 4 leading 8 leading SIC industry segment companies companies companies X-ray and electromedical equipment (SIC 3693) OTT 212 32% 51% 1068 56 67 79 Surgical and medical instruments (SIC 3841) 1077 575 32 48 1083 256 47 58 Surgical appliances and supplies (SIC 3842) 1077 1,017 38 49 1088 525 49 58 Dental equipment and supplies (SIC 3843) Te 507 33 46 1063 267 37 50 Ophthalmic goods (SIC 3851) 1077 593 45 56 1063 Le 211 53 62 SOURCES: US. Department of Commerce, Bureau of the Census, Census of Manufactures, Industry Series, for years 1963 and 1977, as cited in U.S. Department of Health and Human Services, Food and Drug Administration, Office of Planning and Evaluation, Baseline Data on the Availability of Medical Devices and In-Vitro Diagnostic Products, OPE Study 54, Washington, DC, 1980. 1963, with the possible exception of SIC 3841 (sur- gical and medical instruments), whose ratio in- creased slightly from 1972 to 1977. As one would expect, the field appears to be much more concentrated at the level of more spe- cific products. The 1977 Census of Manufactures reported the number of companies with shipments of $100,000 or more for each product line. SIC 3693 (electromedical equipment) had four prod- uct types with only one manufacturer, and SIC 3842 (surgical appliances and supplies) had one product with a single manufacturer (393). The products in the other SIC codes, which varied in their level of detail, all had more than one man- ufacturer, although the numbers were sometimes small. Data from IMS America on sales to hospitals indicate that a small number of companies have a large share of the market for specific devices (table 14). For sutures, the four leading companies accounted for 99.9 percent of all sales. Market shares over 96 percent were also held by the four leading firms in surgeons’ needles, blood collec- tion supplies, and ostomy products (for discharge of intestinal contents or urine through an artifi- cial opening). The lowest market shares of the four leaders, which were still substantial, were 43 percent for garments, textiles, and gloves and 45 percent for respiratory therapy devices. Several companies have large market shares across a range of products. As shown in table 15, American Hos- pital Supply Corp. is one of eight leading firms in 21 of the 28 product categories listed in table 14, and Johnson & Johnson is one in 14. Prices for products in SIC medical devices codes have increased at rates comparable to those in other manufacturing industries. Available indexes measure price changes in a given market basket of products and do not incorporate new products or changes in old ones, a serious deficiency for the innovative medical devices field. From 1972 to 1982, product prices rose at an annual rate of 9.5 percent for SIC 3693 (X-ray and electromedi- cal equipment), 8 percent for SIC 3841 (surgical and medical instruments), 7.3 percent for SIC 3842 (surgical appliances and supplies), 7.7 per- cent for SIC 3843 (dental equipment and supplies), and 5.9 for SIC 3851 (ophthalmic goods) (369, 375). During that time, product prices increased at an annual rate of 9.2 percent for all manufac- turing industries and 6.7 percent for the electri- cal and electronic equipment industry. The lower rate of price increase in ophthalmic goods is consistent with the case of contact lenses. From 1971 to 1982, the list price of soft contact lenses fell 50 percent, a result of competition among fitters as well as among producers of the lenses (275). The mature hard lens sector, which exhibits little evidence of economies of scale in production, has few dominant firms and has been highly price-competitive for several years. In the 30 e Federal Policies and the Medical Devices Industry Table 14.—Leading Companies’ Market Share of Hospital Sales of Medical Devices, 19822 Percent market share Sales to hospitals 4 leading 8 leading SIC codel/product (thousands of dollars) companies companies X-ray and electromedical equipment (SIC 3693) X-ray SUPPHES «ove eee $77,366 89.3% 98.2% Radiological catheters and guide wire ......................... 135,878 85.3 92.8 Pacemakers and other cardiovascular products ................. 499,999 73.7 88.9 Electrosurgical SUPpPliesS ......oouiii 48,552 58.9 82.6 Surgical and medical instruments (SIC 3841) Surgeons’ NEEdIBS ... oo. iii 4,310 96.5 99.6 Blood collection supplies ...........oiiiiiiiiiiiinii. 57,845 96.4 99.1 THEM OME EIS ttt tt te eee ee eee ees 31,426 78.8 92.3 Surgical instruments .......... ii 294,284 68.1 81.2 Syringes and needles .......... iii 331,054 65.7 80.9 Catheters, tubes and allied products ........................... 235,445 60.8 81.6 Diagnostic instruments ............. 69,549 59.5 77.8 Surgical appliances and supplies (SIC 3842) SUIUTES ott t tee eee eee 286,635 99.9 100.0 OStOMY ProdUCES «oo voit ete eee 13,842 97.9 99.6 Surgical packs and parts ..........ooi ii 174,123 84.1 95.1 Maternity products... 26,869 82.3 91.8 Dialysis supplies «o.oo 97,677 81.5 93.3 Cardiopulmonary supplies ...........oiiiiiiiiinenann. 71,176 79.4 98.0 SPONGES + + vette tte 174,768 © 78.9 88.4 Bandages, dressings and elastic 172,303 77.3 87.5 Orthopedic supplies .........iiiii 302,283 74.5 83.8 Parenteral supplies . o.oo 701,106 72.6 91.9 Urological products... occu 198,970 71.7 86.8 Sterilizer supplies «o.oo 88,846 71.4 83.5 Cast room supplies «oui 39,836 62.2 78.6 Disposable Kits and trays. ............ooi iii 258,317 46.7 63.1 Respiratory therapy ..........coii i 245,890 451 67.4 Garments, textiles, and gloves ............. ii 592,254 43.7 61.1 Ophthalmic goods (SIC 3851) Ophthalmic-related products .................ouiiiiiiiinnnnnnn 83,649 67.9 93.3 a]MS America’s Hospital Supply Index also has nine other categories that are not included here: elastic goods, identification supplies, solutions, chemicals and soaps, gases, medical supplies, paper products, rubber goods, and underpads. SOURCE: IMS America, Ltd., Rockville, MD, unpublished data, 1983. Table 15.—Eight Leading Companies in Hospital Sales of Medical Devices in Three or More Product Categories, 19822 Number of product categories Number of product categories in which company is one of in which company is one of Company eight leading companies Company eight leading companies American Hospital Brunswick Corp.......... 4 Supply Corp. .......... 21 Lilly... 4 Johnson & Johnson ..... 14 Cordis/Cordis Dow... ..... 3 Colgate-Palmolive ....... 8 Dart Industries .......... 3 Baxter-Travenol ......... 7 Independent Lab ........ 3 Bard, C.R. .............. 6 Kimberly-Clark .......... 3 Pfizer ........iiit. 6 Professional Med. P. ..... 3 Abbott ................. 5 Squibb... 3 Bristol-Myers. ........... 5 Terumo-America Inc. ..... 3 Minnesota 3M Labs ...... 5 Warner-Lambert ......... 3 Becton Dickinson ....... 4 20ut of the 28 product categories listed in table 14. SOURCE: IMS America, Ltd., Rockville, MD, unpublished data, 1983. Ch. 2—Characteristics of the Medical Devices Industry ¢ 31 younger soft lens sector, the four leading firms control almost 70 percent of the market, but new firms have entered and the concentration level has declined steadily during the past 5 years. There is some evidence that merger activity in the medical devices field accelerated during the latter part of the 1970s. Respondents to a survey in 1981 said that only 4 percent of their companies had been acquired by another firm, merged with another firm, or acquired another firm from 1972 to 1975, but 23 percent answered affirmatively for 1976 to 1980 (197). By 1982, 100 of the 140 firms belonging to the Pharmaceutical Manufacturers Association produced diagnostic products and other medical devices, accounting for an estimated 60 percent of all such sales (244). INNOVATION IN MEDICAL DEVICES A hallmark of the medical devices field has been the introduction of new products and the refine- ment of old ones. Some innovations affect or- dinary devices that are used frequently, such as assembled surgical trays for operating rooms (2). Others represent the application of sophisticated technology to medical uses, such as nuclear mag- netic resonance imaging.¢ This rapid innovation in medical devices has certainly underlain much of the growth in firms and sales in recent decades. Although innovation in medical devices has not been precisely documented, striking evidence is provided by the changes in medical practice that have resulted from new medical devices. In boxes A and B, respectively, a pathologist and an oph- thalmologist relate certain changes in clinical lab- oratories and ophthalmology that have been linked to innovations in devices. Innovative devices have been the basis for tremendous changes in clinical laboratory procedures. Compared to a generation ago, clinical laboratory tests can now be per- formed more accurately and quickly as well as with fewer, less skilled personnel and at lower cost. The pace of innovation in ophthalmology de- scribed in box B is greater than one might expect from the relative growth of the SIC code 3851 (ophthalmic goods). However, many of the new or refined medical devices used in ophthalmology are surgical instruments or electromedical equip- ment, which appear in other SIC codes. Similar innovations have taken place in other areas of medicine, such as digital subtraction angiography ¢See the separately published OTA case study on nuclear magnetic resonance imaging by Steinberg and Cohen (291). and CT scanning in diagnostic imaging and pace- makers and materials for hip joints in surgery. Patents are frequently used as a measure of in- novative activity in an industry. Such data have limitations since not all inventions are patented, several patents may pertain to a single invention, and the propensity to patent is greater in some fields than in others. The number of patents granted by the U.S. Pat- ent Office grew modestly through the 1970s. From 1968 to 1979, almost 22,000 applications were filed for medical devices patents that were subse- quently issued (table 16), representing 2 percent of all patents (381). Compared with all U.S. patents over the same period of time (see app. D, table D-2): 1) while all patents have remained essentially constant, medical devices patents in- creased moderately; and 2) while foreign-origin medical devices patents as a percent of total med- ical devices patents increased from 20 to 30 per- cent over the 1970s, foreign-origin patents for all U.S.-issued patents increased from about 30 to 40 percent. Individuals owned 37 percent of the med- ical devices patents, compared with 22 percent of all patents, an observation suggesting the impor- tant role of individuals in the medical devices field. Table 17 provides information on patenting activity in specific medical device fields (see app. D for further information on patents). Electrical systems and diagnostic equipment using radiation, for example, accounted for about 6 percent of all medical devices patents. Strength in this area is consistent with the rapid growth in sales, firms, and employment that has characterized the related segment of the medical devices industry (X-ray, 32 e Federal Policies and the Medical Devices Industry Ch. 2— Characteristics of the Medical Devices Industry 33 34 e Federal Policies and the Medical Devices Industry Table 16.—U.S. and Foreign Medical Devices Patents Granted by U.S. Patent Office by Application Date, 1968-79 Number Annual percentage change United United Year Total States Foreign Total States Foreign 19792. LLL. 2,142 1,488 654 5.3% 2.0% 13.5% 19782... 2,035 1,459 576 -4.8 -7.0 1.4 1977 2,137 1,569 568 3.8 1.6 10.7 1976 LL... 2,058 1,545 513 3.2 0.1 13.7 1976 LL 1,994 1,543 451 -0.5 1.8 -5.8 1974 ©... 1,995 1,516 479 6.6 4.0 15.7 1973 1,871 1,457 414 9.4 8.1 14.0 1972 1,711 1,348 363 4.0 -1.0 28.3 1971 1,645 1,362 283 6.1 8.2 -2.7 1970 o.oo 1,550 1,259 291 9.1 9.2 8.6 1969 ................ 1,421 1,153 268 12.7 9.9 26.4 1968 ................ 1,261 1,049 212 — - —_ Total .............. 21,820 16,748 5,072 8The average pendency (i.e., the delay between the filing of a patent application and its subsequent issuance as a patent) is currently longer than 2 years. It is estimated that 2 to 5 percent of the 1979 applications and 1 percent of the 1978 applica- tions were still pending in June 1983. SOURCE: U.S. Department of Health and Human Services, Food and Drug Administration, Office of Economic Analysis, Rockville, MD, compilation of unpublished data from the U.S. Patent and Trademark Office, December 1983. Ch. 2—Characteristics of the Medical Devices Industry ¢ 35 Table 17.—U.S. and Foreign Medical Devices Patents Granted by U.S. Patent Office by Source and Selected Categories, 1968-79 Total number Percentage of totalb of U.S. and U.S. Category foreign patents® Corporations ~~ Government Universities Individuals Diagnostic equipment ................... 3,037 56% 4% 3% 37% Respiratory methods .................... 1,042 55 2 c 43 Electrical systems ...................... 723 68 1 2 29 Implantable artificial body members ............... 1,236 48 4 4 44 Dialysis and blood filters ................ 440 68 4 2 26 Kinesitherapy equipment ................ 1,015 32 1 1 66 Orthopedic devices ..................... 590 21 1 1 76 Bandages and trusses ................... 1,880 46 1 1 52 Medicators. .....coov viii 2,502 61 1 1 37 Instruments ............ iii 2,290 49 1 1 49 Dental equipment.................. LL. 1,509 33 c 1 66 Ophthalmic equipment .................. 1,110 59 1 1 39 Miscellaneous, including incubators, hearing aids, receptors, and baths ...... 2,525 58 2 1 39 includes patents granted (as of June 1983) on applications filed from 1968-79. The average pendency (i.e., the delay between the filing of a patent application and its subsequent issuance as a patent) is currently longer than 2 years. It is estimated that 2to 5 percent of the 1979 applications and 1 percent of the 1978 applications were still pending in June 1983. One patent may be included in more than one category. Percentages may not add up to 100 percent because of rounding. CLess than 1 percent. SOURCE: U.S. Department of Health and Human Services, Food and Drug Administration, Office of Economic Analysis, compilation of unpublished data from the U.S. Patent and Trademark Office, December 1983. electromedical, and electrotherapeutic equipment, SIC code 3693). Considerable activity also oc- curred in dialysis and blood filters, whose use has been covered by Medicare since 1972 (see ch. 3), and in diagnostic and implantable cardiovascular devices (see ch. 5). Both large and small firms play a role in the innovation of medical devices, as they do in other sectors of the U.S. economy (274). There is no exact information, however, on the dynamic rela- tionship between large and small medical device companies. It has been suggested that small firms introduce innovative devices and, after proving their commercial potential, merge or are acquired by larger, more stable companies (18). It is also possible that larger companies and establishments benefit from economies of scale, while the smaller ones specialize in products or functions that are not so dependent on scale (393). INTERNATIONAL COMPETITIVENESS OF U.S. MEDICAL DEVICES The United States has commanded a strong position in the foreign trade of medical devices. During the past decade, the surplus of U.S. med- ical devices exports over imports grew steadily un- til 1982. In 1983, the surplus fell from over $1 bil- lion in 1982 to about $800 million (table 18). The $2.3 billion of medical devices exported in 1982 represented 17 percent of total sales (22,368). From 1978 to 1981, U.S. exports of medical devices grew about 19 percent a year, a substantial amount even though it does not allow for the 9 percent U.S. inflation rate at that time (219).” U.S. foreign trade in medical devices contrasts with U.S. total merchandise trade, which has run a deficit (imports exceeded exports) for all but 2 years (1975 and 1976) since 1973 (358). The U.S. ’See app. H on consensus standards related to international trade and app. I on governmental regulation of foreign trade in medical devices by six countries. 36 ¢ Federal Policies and the Medical Devices Industry Table 18.—U.S. Exports and Imports of Medical Devices by SIC Code, 1979-83 Millions of dollars Percent change SIC code 1979 1980 1981 1982 19832 1982-83 X-ray and electromedical equipment (SIC 3693) Exports ......... $ 717 $ 839 $1,006 $1,026 $1,065 3.8% Imports ............ 275 312 388 487 670 37.6 Surplus (deficit) ......................... 442 527 618 539 395 — Surgical and medical instruments (SIC 3841) Exports ............... 410 485 566 605 585 -3.3 Imports ............. 146 174 195 222 255 14.9 Surplus (deficit) ................... 264 311 371 383 330 — Surgical appliances and supplies (SIC 3842) Exports ........ 258 309 356 375 395 5.3 Imports... 105 94 95 108 110 1.9 Surplus (deficit) ......................... 153 215 261 267 285 or Dental equipment and supplies (SIC 3843) Exports ............. 101 127 140 143 155 8.4 Imports ......... 42 41 50 50 55 10.0 Surplus (deficit) ......................... 59 86 90 93 100 no Ophthalmic goods (SIC 3851) Exports ....... 99 114 123 113 110 -2.7 Imports ................. 245 278 300 342 452 32.2 Surplus (deficit) ......................... (146) (164) (177) (299) (342) —_ Total, five SIC sectors Exports .............. $1,585 $1,874 $2,191 $2,262 $2,310 2.1% Imports... $ 813 $ 899 $1,028 $1,209 $1,542 27.5% Surplus (deficit) ......................... $ 772 $ 975 $1,163 $1,053 $ 768 —_— 8Estimated. SOURCES: W.C. Bandy, U.S. Department of Commerce, Bureau of Industrial Economics, Washington, DC, personal communication, January 1983; E. Arakaki, U.S. Department of Commerce, Washington, DC, personal communication, February 1984; U.S. Department of Commerce, Bureau of Industrial Economics, 1984 U.S. Industrial Outlook, Washington, DC, January 1984. position in medical devices is especially note- worthy because the growing strength of the dollar during the last decade increased the relative price of U.S. exports as it decreased the price of U.S. imports. That phenomenon did erode the U.S. surplus in 1983. The surplus in medical devices trade has also persisted during the recent recession, despite the reduced buying power of our major trading partners. In 1983, the European Economic Community was the outlet for 37 percent of U.S. exports of medical devices, but Canada (14 percent) and Ja- pan (10 percent) were the major individual pur- chasers.® The European Economic Community also provided more than half of U.S. imports, with West Germany (32 percent) and Japan (18 percent) the largest single sources (369). Although U.S. production is greater in other categories of medical devices, SIC 3693 (X-ray and electromedical equipment) leads exports, with $1 billion or almost 50 percent of all U.S. foreign sales of medical devices. Domestic production in #These figures relate to SIC codes 3841, 3842, 3843, and 3693 but exclude SIC code 3851 (ophthalmic goods). this category is heavily tied to export: 30 percent of electromedical equipment and 24 percent of X- ray equipment in 1983 were sold overseas (369). As a result, sales of these devices are more de- pendent on fluctuations in exchange rates. Electromedical equipment, with exports that grew almost 25 percent annually from 1978 to 1981, accounts for most of the trade surplus in SIC 3693 (219). Although it is common that the U.S. share of the world market for a product de- clines over time as other countries enter the field and U.S. growth falls behind a faster growing world market, this situation has not occurred with electromedical equipment. The U.S. share of the world market increased from 35 percent in 1975 to 47 percent in 1979 (219). Patient monitoring systems and other diagnostic electromedical appa- ratus have accounted for the majority of these ex- ports (371,372). In 1981, Japan, Canada, the Netherlands, West Germany, and France purchased almost half of U.S. exports in this subcategory. Trade in X-ray products has been less favorable. In 1982, exports only slightly exceeded imports. A deficit of $175 million was expected for 1983, Ch. 2—Characteristics of the Medical Devices Industry e 37 with imports accounting for 33 percent of U.S. consumption of all X-ray products (369). About 40 percent of all X-ray products imported during 1981 and 1982 were X-ray apparatus and parts from West Germany (373,374). Although SIC 3841 (surgical and medical instru- ments) showed a trade surplus in 1983, its posi- tion deteriorated from 1982: exports fell 3 percent and imports grew 15 percent. About 15 percent of the surgical and medical instruments produced in the United States during 1983 were exported, but only 7 percent of U.S. consumption came from imports. Exports of surgical and medical in- struments indicate the untapped potential of mar- kets other than our traditional trading partners. From 1978 to 1981, exports to Canada (17 per- cent) and the European Economic Community grew about 12 percent per annum. Exports to the Middle East (10 percent) and Latin America (18 percent), however, grew nearly 30 percent per an- num (219,371). SIC 3842 (surgical appliances and supplies), the largest medical devices category in sales, has the least relative involvement in foreign trade: only 7 percent of production is exported, and 2 per- cent of U.S. consumption is imported (369). From CONCLUSIONS The medical devices industry can be charac- terized as a field that has undergone enormous growth in companies, establishments, employ- ment, new products, and foreign trade. By all of these measures, the experience of the medical devices industry has exceeded that of manufac- turing as a whole and of similar manufacturing sectors. Growth in medical devices has apparently occurred more by the addition of new companies than by the expansion of old ones, an indication that any barriers to entering the industry are not prohibitive. Both small and large firms have im- portant positions in this industry. Small com- panies are responsible for a greater percentage of sales in the medical devices industry than in other industries. But large companies have accounted for the majority of sales, and a small number of 1982 to 1983, exports experienced a 5-percent in- crease, and imports rose almost 2 percent. Both West Germany and Japan had sizable increases in their exports to the United States. Exports of devices in SIC 3843 (dental equip- ment and supplies), representing 12 percent of production, increased 8 percent from 1982 to 1983. Imports, only about 5 percent of U.S. con- sumption, came mainly from West Germany and Japan (369). SIC 3851 (ophthalmic goods) is the only medi- cal devices code that has had a persistent trade deficit. Half of the imports consist of frames and mountings for eyeglasses, which are supplied pri- marily by France, Italy, Japan, and Hong Kong. Sunglasses, 38 percent of ophthalmic imports in 1981, came mainly from Japan and Hong Kong (373). Unlike most products in the other medical devices codes, ophthalmic goods are usually cho- sen and used by consumers rather than by medi- cal providers. To the extent that use is discre- tionary or postponable, sales would be expected to be more sensitive to changes in price and gen- eral economic conditions. That reduced exports in sunglasses accounted for most of the fall in ex- ports from 1981 to 1982 fits this pattern. firms have a considerable share of the market, especially in specific product lines. There are, however, disquieting aspects to the situation. This phenomenal growth has occurred in a market where there is a consensus that tech- nology, including medical devices, has sometimes been used excessively (168,266,346). Policy ini- tiatives, both public and private, are now under way to improve the situation, chiefly by chang- ing the way that medical providers are paid. In addition, Federal policy regarding premarket ap- proval of devices is under review. It is therefore timely to analyze the likely effects on the medi- cal devices industry of these and other policies, a task that is undertaken in the remainder of this report. oo 3. Payment Policies for Health Care and Medical Devices INTRODUCTION The market for health care services is more complicated than most other sectors of the econ- omy. The ultimate consumers of health care typi- cally do not pay for services at the time they are . rendered; third-party payers—insurance com- panies, Medicare, Medicaid, and other Govern- ment programs—share in the cost of providing medical services to their beneficiaries. Only about 32 percent of total personal health care expendi- tures are paid directly by patients (128). The market for health care services is also com- plicated by the central role of the provider—the physician, other health professional, or hospital — in making decisions about the amount, kind, and quality of services that the patient receives. Most diagnostic and therapeutic medical procedures, prostheses, and implants must be ordered by the physician. Thus, the makers of medical devices more frequently see the provider as the buyer than they do the patient or consumer.! Manufacturers of medical devices, like those of other products, try to produce and price prod- ucts to meet the demands of their market. If low price is important to buyers, then, barring the ex- istence of monopoly power,? the producers will attempt to make products that can sell profitably at low prices. If price is not so important to cus- tomers, producers will focus on factors that are. Since the system of third-party payment for health care services influences the products that will be bought and the prices that will be paid, it is a ma- jor determinant of the market for medical devices. Payment issues also influence the long-run per- formance of the industry. In general, the success 1An important and growing class of devices are those made ex- pressly for use in the home or by the consumer. These include self- care products such as self-testing diagnostic kits and aids for hand- icapped people that are often marketed directly to the consumer. This assumption is important in gauging the response of the in- dustry to the preferences of consumers. 25-406 O - 84 - 4 or failure of a technological innovation rests partly on developers’ perceptions of its market (201,232,264). Although technological oppor- tunities may dictate what directions of advance are feasible, the perceived existence of a market for an innovation is necessary for the commitment of research and development (R&D) funds or the investment in commercialization. There is no evidence to suggest that the medical device indus- try is different from other industries in this regard. Other factors besides the payment system shape markets for medical devices. Both the benefits and costs of medical devices matter. First, the buyers and users must perceive a device to be worth- while. Devices that are unsafe, ineffective, or less effective than their substitutes may not have a market even in the presence of generous third- party payment. Gastric freezing is an example of a device-bound procedure that was abandoned soon after evidence accumulated that it did not help ulcer victims, in spite of the willingness of third-party payers to finance its use (114). How- ever, many devices have been widely used even though well-documented evidence of their effec- tiveness is lacking. Second, the availability of an important new device whose cost, configuration, or setting of use currently limits or proscribes third-party payment can stimulate a change in payment policy. The case of long-term hemodialysis therapy for end- stage renal disease is a classic example (256). With the development of a subcutaneous arteriovenous shunt (a plastic tube connected to an artery and a vein in the arm or leg) by Quinton and Scribner in 1960, hemodialysis rapidly became accepted as a life-extending therapy for victims of chronic kidney failure. In 1972, Congress extended Medicare coverage for treatment of end-stage renal disease to the gen- 41 42 e Federal Policies and the Medical Devices Industry Photo credit: National Kidney Foundation, Washington, DC This man is undergoing hemodialysis for the treatment of end-stage renal disease (ESRD). Medicare began paying tor such treatment in 1973, and by 1982, expenditures for Medicare’s ESRD program were an estimated $1.8 billion. eral population (Public Law 92-603), largely out of a recognition that there occurred an estimated 7,000 to 10,000 deaths per year because of the limited availability of dialysis facilities (256). This program now pays $1.8 billion annually for hemo- dialysis for approximately 80,000 people (98). Third, many new medical devices are perceived to have such benefit that they are demanded whether or not they are covered by insurers. In dentistry, for example, many new materials have been developed in the recent past (184,210), de- spite the fact that almost 70 percent of dental ex- penditures are paid directly by patients (128). With the recognition that other factors affect the markets for medical devices, this chapter de- scribes how third-party payment, particularly Federal payment programs, affects the kinds of medical devices that are produced, the settings in which they are used, and the prices at which they sell. Medicare and Medicaid, the two Government health insurance programs, are responsible for about 35 percent of payments for personal health care made to hospitals, 23 percent of those to phy- sicians, and 23 percent of all other medical ex- penditures (128). Private health insurance, in- cluding commercial (for-profit) insurance companies and (not-for-profit) Blue Cross/Blue Shield plans, accounts for another 33 percent of hospital and 35 percent of physician expenditures. Other Fed- eral, State, and local government programs also contribute 13 percent of personal health expend- itures through the Veterans Administration (VA), the military medical system and its related Civil- Ch. 3—Payment Policies for Health Care and Medical Devices © 43 ian Health and Medical Program of the Uniformed Services (CHAMPUS) program, and Government owned and operated health facilities (128). If all sources of third-party payment and Gov- ernment funding are taken together, the individ- ual consumer or patient bears a moderate propor- tion of the burden of personal health care expend- itures in this country (32 percent). But the distri- bution varies widely by settings and types of tech- nology. Patients pay only about 12 percent of hos- pital expenditures directly, but they pay 37 percent of payments to physicians and almost 77 percent of expenditures for eyeglasses and appliances (128). The burden of payment also varies widely in the population. Some people have comprehen- sive health insurance, although an estimated 32.7 million people under age 65—or about 16 percent of the population under age 65—were without any public or private insurance coverage in 1982 (295a).2 3The uncovered population increased dramatically between 1979 and 1982. In 1979, 14.4 percent of those under 65 years of age were uncovered, and in 1982, 18.9 percent of those under 65 were un- Three aspects of third-party payment can in- fluence the potential market for medical devices: e the coverage of devices as benefits by third- party payers; ¢ the methods used to determine the level of payment for covered health services; and e the financial relationship between the payer and the provider of health care. Each of these elements is discussed in the sec- tions below. covered. Economic conditions in the period and increases in the costs of health insurance relative to other goods and services are respon- sible for these changes (295,296). THIRD-PARTY COVERAGE OF MEDICAL DEVICES Economic theory predicts and empirical evi- dence confirms that the existence of insurance cov- erage for a technology increases the number of such services used (29,233,279). It has also been shown that the use of physician and hospital serv- ices varies inversely with the amount of cost- sharing required of the consumer (233). Not only have people sought care less often under cost- sharing, but their total annual health expenditures have been lower than for people without cost- sharing requirements. Insurance coverage also af- fects the adoption of new medical technologies. In two studies, a positive relationship was found between the proportion of a State's population with health insurance and the adoption of complex and sophisticated facilities in hospitals (71,266). Most health insurance plans are selective in their definition of covered technologies. Insurers avoid certain services whose use may be difficult to predict or control. For example, mental health services are frequently excluded from both pub- lic and private insurance policies, as are some long-term care and home health services (55). The Medicare program covers inpatient hospital care more fully than other services but requires some cost-sharing by beneficiaries and limits the num- ber of hospital days covered. Physician services and ambulatory laboratory services are covered, but annual deductibles and copayments are re- quired of beneficiaries. Other services, such as outpatient drugs, eyeglasses, hearing aids, and preventive services are either uncovered or cov- ered to a very limited extent under Medicare (345). Coverage decisions are often more complicated than the all-or-nothing decision about general classes of services. By statute, Medicare may pay 4Medicare consists of two separate but coordinated programs— Hospital Insurance (Part A), and Supplementary Medical Insurance (Part B). Under Part A, beneficiaries receive up to 60 full days of hospital care per year after a deductible is satisfied. Part B, which is voluntary and requires a premium, has both a deductible and a beneficiary payment of 20-percent coinsurance. 44 » Federal Policies and the Medical Devices Industry only for services that are “reasonable and neces- sary” for diagnosis, treatment, or improved func- tioning of a malformed body member. Medicare has refrained from establishing a definitive inter- pretation of reasonable and necessary and has relied on a loosely structured and decentralized mechanism to determine whether a specific serv- ice is covered. Under the present Medicare pro- gram, funds are passed from the Federal Govern- ment to many separate contractors (referred to as intermediaries and carriers) who reimburse pro- viders or consumers for the services delivered in their area.® The contractors are responsible for implement- ing Medicare coverage policy. Decisions involv- ing coverage of services, particularly new serv- ices, are often made on a case-by-case basis and thus may vary from region to region. For exam- ple, prosthetic devices may be covered under Medicare if they replace all or part of an internal body organ or replace the functioning of a per- manently inoperative or malfunctioning organ. But communications aids, considered by numer- ous health professionals to be prosthetic devices, are not specifically covered under Medicare. Cov- erage is largely at the discretion of the contrac- tor (345). A rather informal system exists for referral of coverage issues that cannot be resolved by the contractor to Medicare's regional office and, if necessary, to the Federal Health Care Financing Administration (HCFA), which often turns to the Office of Health Technology Assessment® in the Public Health Service for guidance. There is ap- parently some chance involved in which issues get flagged for referral (343). Medicare contractors vary widely in their iden- tification of uncovered technologies, the decisions sCoverage is important for new devices where payments are made for each service delivered as in a fee-for-service system. In Medi- care, coverage affects the services of physicians and other health professionals more than hospitals, because they are paid on a fee- for-service basis whereas hospitals are paid by the admission. ¢The Office of Health Technology Assessment (OHTA) in the De- partment of Health and Human Services is the office in the Public Health Service that is charged with advising HCFA on Medicare coverage of specific technologies. OHTA is distinct from the Of- fice of Technology Assessment (OTA), a staff agency of Congress that performs studies requested by congressional committees and has a Health Program. they make concerning the coverage of specific technologies, and their implementation of cover- age decisions (51,79,343). In short, coverage of some services, particularly new procedures, under Medicare is variable and uncertain. Such uncer- tainty may reduce in the eyes of the developer the expected monetary return from introducing a new medical device whose coverage is questionable. Increasingly, the manufacturers of new devices have themselves approached HCFA for definitive guidance on coverage (345), perhaps in an attempt to reduce the interregional variation and uncer- tainty associated with the coverage process. In general, third-party payers will not cover a new device until it is approved for marketing by the Food and Drug Administration (FDA) (see ch. 5). For example, Medicare will cover no drug or device that is in the investigational category. It is interesting to note, however, that the Medical Device Amendments of 1976 (Public Law 94-295) do not prohibit the manufacturers of an investiga- tional device from selling their product to users. The producer may charge a price for an investiga- tional device that will recoup research, develop- ment, and production costs but may not make a profit. Although the buyers (health care providers) generally cannot charge third-party payers di- rectly for an investigational device, they can sometimes charge for it through other, similar, procedures that are already covered.” In the words of one legal expert, “investigational devices pay their own way” (84). This expert also noted that large and small device-makers charge institutions, practitioners, and patients for devices that are available only under an FDA investigational de- vice exemption (IDE). Some investigational devices have become widely diffused in the absence of either premarket ap- proval or specific coverage by the major third- party payers. As an example of FDA's policy of limiting distribution of devices under IDE, the agency recently issued a “guidance” letter to nine manufacturers of yttrium aluminum garnet (YAG) lasers (used in ophthalmology) limiting investiga- tional uses to 500 patients in a 6-month period ’If the device is part of a research program, a research grant may pay for its use. Ch. 3—Payment Policies for Health Care and Medical Devices © 45 because it was concerned that the widespread dis- tribution of these devices still in the investigation stage constituted commercialization (88). Limitations on and exclusions from coverage increase the difference between the out-of-pocket price of covered and uncovered services. When covered and uncovered services compete as sub- stitutes for one another, the uncovered services are at a distinct disadvantage. To have a chance of being used, the uncovered service would have to offer patient benefits sufficiently greater to justify the higher out-of-pocket expense. The ef- fect of differential coverage levels on the market for a medical device depends, of course, on whether the device is covered by most insurance plans, which patient conditions are covered for payment, whether substitutes for the device exist—and if substitutes exist, whether these alternative serv- ices are covered under insurance policies as well. The effects of a coverage decision on medical devices vary with the specific characteristics and conditions of use of devices. For example, a new cataract removal procedure made possible by a new device may lower the cost to the physician of performing the procedure. The physician can introduce the cost-saving method and bill the pa- tient or insurer for the standard cataract removal procedure (at fees that are not likely to reflect the reduced costs).? Thus, to the extent that new tech- niques or devices can be subsumed under existing medical procedure categories, coverage is not of great concern. However, if the cost of the new approach is higher than the level of payment for existing procedures, coverage becomes an impor- 8See the section below on “Payment for Physicians devices” for an explanation of this phenomenon. tant milestone in the development of a viable mar- ket for the technique. Using old procedure codes for the new technique will not be attractive to physicians. Although the introduction of some new medi- cal devices may be discouraged by the practical obstacles to third-party coverage, there is no ongoing mechanism in Medicare to reverse cov- erage decisions when an existing device has been found to be less effective than other approaches. For example, Medicare has continued to cover in- termittent positive pressure breathing (IPPB), a mechanical ventilator for respiratory therapy (246,272), despite the fact that several professional societies have seriously questioned its value. The history of IPPB also illustrates the impor- tant role of professional judgment in influencing the use of a procedure. Despite the coverage by third parties, the use of IPPB has decreased dra- matically in the past decade (see box C) (20,43, 49,248,272). Thus, it appears that the process by which devices come to be covered (or removed from cov- erage) by third-party payers is idiosyncratic. Under Medicare, some devices are “grandfathered” into coverage by virtue of their age; some are cov- ered by default because they can be paid within preexisting medical procedure codes. Others are denied coverage, or given very limited coverage for a period of time. The degree of ease with which a particular device receives the blessing of cover- age from the major third-party payers appears to have little to do with the device's relative efficacy or cost effectiveness (24) and more to do with the accident of timing of its introduction to medical practice. METHODS OF THIRD-PARTY PAYMENT AND THE DEMAND FOR MEDICAL DEVICES Insurers use a variety of mechanisms to pay for covered services provided to their beneficiaries. In the simplest case, the insurer makes fixed in- demnity payments to the beneficiary, who is re- sponsible for paying the provider whatever is charged. Other plans pay for the full costs of serv- ices to the beneficiary (less any deductibles and coinsurance) up to a schedule of maximum al- lowances. Medicare, Medicaid, and many Blue Cross/ Blue Shield plans enter into contracts with “par- 46 e Federal Policies and the Medical Devices Industry Ch. 3—Payment Policies for Health Care and Medical Devices * 47 ticipating” providers that specify the methods for determining the level of payment that providers will receive. Because of the importance of Medi- care, Medicaid, and the Blue Cross/Blue Shield plans as sources of revenue, these methods of pay- ment are critical determinants of the market for medical devices. Methods of payment vary widely across in- surers and settings of care. This section will focus on current and proposed methods of paying for inpatient hospital care, physicians’ services, lab- oratory tests provided in ambulatory care settings, and services or devices used in the home. These four components constitute over 80 percent of health expenditures and make intensive use of “medical devices. Hospital Payment Public and private third-party payers were re- sponsible in 1980 for over 83 percent of the reve- nues of community hospitals in the United States (108). Private health insurance itself accounts for 38 percent, while Medicare and Medicaid com- prise 42 percent. Individual patients are the source of about 17 percent of the revenues of commu- nity hospitals. Third-party payment for hospital care has tradi- tionally taken two forms: payment of billed charges and payment of incurred costs. Most commercial insurance plans and about one-third of the 70 Blue Cross plans pay hospitals their billed charges.® In 1981, over one-half of the State Medicaid pro- grams and about one-half of the Blue Cross plans reimbursed hospitals for the “reasonable costs” incurred in serving their beneficiaries (6,345). Medicare is in the process of abandoning this method of payment and moving to a new system, discussed later in this chapter. Both of these pay- ment methods (by charges and costs) pass the im- mediate burden of payment through the patient to the third-party payer. Charge- and cost-based third-party payments encourage increases in health care expenditures, because hospitals have no incentive to hold costs °A small percentage of commercial policies are indemnity plans, where the insurer pays the patient a fixed amount, such as $100 per day of hospitalization. Only about 10 percent of group policies writ- ten by commercial insurance companies are indemnity plans (456). down.’ Only to the extent that patients them- selves react to costs (or charges) by taking their business elsewhere (if they can) will the hospital have an incentive to compete for patients in terms of price. Since patients themselves pay so little out-of-pocket for inpatient care, they have little incentive to concern themselves with price. The predominance of third-party cost- and charge- based payment has been held responsible for the rapid increase in hospital expenditures (110). The problem of growing hospital expenditure inflation increased during the 1970s and led both public and private third-party payers to modify payment methods. A number of Blue Cross plans, individual States, and now the Federal Govern- ment have turned to prospective payment. Al- though prospective payment methods vary widely among States and payers, they have two features in common: the amount that a hospital is paid for services is set prior to the delivery of those services, and the hospital is at least partially at risk for losses or stands to gain from surpluses that accrue during the payment period. Evidence has accumulated that in recent years some State-level prospective payment programs, particularly those with relatively stringent sys- tems, have had a moderating influence on hospi- tal costs (33,60). What have these reductions in hospital costs implied for the adoption of medi- cal technology? Three studies of the impact of hos- pital prospective payment programs on the adop- tion of new capital equipment or equipment- embodied services suggest that prospective pay- ment sometimes does affect technology adoption and that the directions of effect depend on both the specific attributes of the programs and the characteristics of the new technology. Joskow found that the number of computed to- mography (CT) scanners located in hospitals in a State in 1980 was negatively related to the num- ber of years that ratesetting had been in effect there (177). Hospital ratesetting also led to a shift in the location of CT scanners to physicians’ of- Such incentives apply when costs of production are reimbursed, as under Medicare, but differ when payments are below costs as under some Medicaid programs (138). Prospective payment has also been called prospective reim- bursement. 48 e Federal Policies and the Medical Devices Industry fices. Cromwell and Kanak analyzed the impact of specific State ratesetting programs on the avail- ability of 13 different services in the hospital be- tween 1969 and 1978 (72). Two States with strin- gent programs, New York and New Jersey, had the most consistently negative effects on the avail- ability of services. Other States’ programs showed no consistent impact on service adoption. Finally, Wagner and colleagues investigated the impact of prospective payment in three States— New York, Maryland, and Indiana—on the adop- tion of five new pieces of capital equipment: elec- tronic fetal monitoring, gastroendoscopy, volu- metric infusion pumps, automated bacterial sus- ceptibility testing, and computerized energy man- agement systems (448). The first three technol- ogies are likely to raise the cost of care, while the latter two are investments in equipment that is cost-reducing in large hospitals. Under New York State's ratesetting program, fewer units of the cost-raising technologies were adopted, and the probability of large hospitals’ adopting the cost- saving equipment increased. However, the pro- spective payment programs in Maryland and Indi- ana showed no such consistent effects on hospi- tals’ adoption behavior. Medicare’s DRG Hospital Payment System In March 1983, Congress established a new Medicare hospital prospective payment system (Public Law 98-21). Beginning in October 1983, Medicare began to phase in a system in which it will pay hospitals a fixed price for treating each admission in 470 separate diagnosis related groups (DRGs) of patients. At this time, the price paid for each admission in a particular DRG covers hospital inpatient operating costs—leaving out- patient, teaching, and capital expenses reimbursed on a cost basis for the time being. The new system is a Medicare-only approach, but the law allows Medicare to join State-run pro- spective plans to cover all kinds of payers. Sup- port from private insurance companies and busi- nesses for these systems is high. Thus, the Federal move into prospective payment may presage a more general adoption of this kind of payment by States. Because Medicare accounts for such a large per- centage of hospital revenues, the new per-case payment system should put into place strong in- centives for hospitals to change their behavior regarding the adoption and use of medical devices, as well as all other inputs, because hospitals will be able to retain any surplus and must bear all deficits. One can expect the adoption of some devices, particularly those that reduce the cost per hospital stay, to be encouraged, relative to their past experience. Compared to practice in the re- cent past, the adoption of cost-raising devices will be discouraged, but the strength of that effect will depend on the device. Some may be less affected if hospitals compete for admissions by adopting new device-embodied services, while others that do not affect the competitive position of hospi- tals are likely to face a more hostile adoption envi- ronment (see box D for more detail). The new Medicare payment system should also alter the settings in which services are delivered to Medicare patients. In particular, the use of nursing homes and home health care should in- crease as hospitals seek to reduce the lengths of stay of Medicare patients. Moreover, payment for care delivered in these settings is not so con- strained as that in the hospital. Devices that can be used in the home should find an increasing market. Some observers are predicting, for example, that the already growing market for parenteral and enteral nutrition (techniques of direct feeding into the bloodstream or gut) in the home will be increased by DRG payment, and that hospitals will enter the market as providers of after-hospital home care in direct competition with other pro- viders, some of whom are manufacturers of equip- ment and supplies for parenteral and enteral nu- trition (34). The law may also influence the pricing behavior of device manufacturers. As hospitals become more price-conscious with the advent of per-case payment, they are likely to increase their use of group purchasing, standardization of purchasing, and competitive bidding for equipment and sup- plies. Group purchasing as a phenomenon has grown rapidly among hospitals in the United States, with an estimated 88 percent of hospitals belonging to a purchasing group in 1981 (99), but Ch. 3—Payment Policies for Health Care and Medical Devices © 49 it is still largely confined to drugs and hospital supplies as opposed to equipment. There is some evidence that the VA has been able to exact significant price concessions from manufacturers through its competitive contract purchasing system (see ch. 7). A recent survey of 25 hospitals in 10 States by the Inspector Gen- eral of the Department of Health and Human Services (DHHS) found that the price of cardiac pacemakers for Medicare patients was about 17 percent higher than the price paid by the VA (427). As hospitals face increasing pressure to reduce the costs per admission under the new payment system, standardization of purchasing behavior is likely to occur, reducing the range of choice open to physicians and allowing hospitals to reap the benefits of increased market power. The ex- 50 e Federal Policies and the Medical Devices Industry pected result in any particular device category is narrower price ranges and less variation among products. An unresolved issue with important implica- tions for medical devices is how Medicare will pay for hospitals’ investments in capital plant and equipment in the future. For the present, the method of payment for capital costs (depreciation, interest, and return-on-equity to for-profit insti- tutions) has not been changed. Capital expendi- tures are reimbursed as they are incurred, on a cost basis. Congress has expressed an intention to include payment for capital by 1986 as part of the prospective payment rate, but no specific method has been selected. The present cost-based method of capital pay- ment is inefficient because hospitals have little in- centive to weigh the costs and benefits of pur- chases and hence are likely to adopt and use medical equipment regardless of the cost effective- ness. Table 19 indicates how hospitals’ incentives to adopt different kinds of capital equipment under DRG payment are influenced by a pass- through of capital (payment of the capital costs that are incurred). -- The capital payment method does not reverse incentives of DRG payment so long as the effect on total hospital costs of a medical equipment pur- chase is in the same direction as its effect on oper- ating costs. For example, DRG payment provides a disincentive to adopt most cost-raising, quality- enhancing (Type I) capital equipment. Regardless of the way capital costs are handled, such pur- chase would raise operating costs. The capital passthrough weakens the disincentive to adopt this kind of technology, but it does not remove it. Since DRG payment sets up incentives for hos- pitals to increase admissions, they have a finan- cial interest to seek cost-raising equipment whose availability promises to bring in profitable admis- sions by attracting physicians and patients. A cap- ital cost passthrough essentially subsidizes this kind of investment, leading potentially to wasteful duplication of these services among hospitals. With equipment that saves operating costs (Type II) or capital costs (Type III), there can be situations where the policy regarding payment for capital may actually reverse the incentives of DRG payment regarding adoption. Of particular con- cern is the incentive under a capital passthrough to adopt expensive capital equipment that reduces operating costs but raises total cost per case. For example, with a capital passthrough, automated laboratory equipment might be evaluated in terms of its ability to reduce operating costs, with in- adequate regard for its impact on total costs. And a more labor-saving capital-intensive system might be preferred regardless of its impact on net costs. New, inexpensive equipment that replaces older, more costly equipment but only at the expense of increasing operating costs (Type III) will also be discouraged in a DRG system with a capital cost passthrough even if its adoption would de- crease total costs (Type III-B). Over time, then, hospitals can be expected to become more capital- intensive than efficiency would dictate if the cap- ital passthrough is continued. Table 19.—Impact of Medical Equipment on Per-Case Hospital Costs Direction of effect of equipment purchase on: Incentives for adoption Capital cost Operating cost Total cost ~~ With capital Without capital Type of equipment per case per case per case in DRG rate in DRG rate I. Cost-raising, quality-enhancing equipment ................ LL... + + + - - Il. Operating cost-saving equipment A. Raises total costs ............ + + - + B. Saves total costs ............. + - - + + Ill. Capital cost-saving equipment A. Raises total costs ............ + + - — B. Saves total costs ............. + - + — ‘SOURCE: Office of Technology Assessment. Ch. 3—Payment Policies for Health Care and Medical Devices ¢ 51 Payment for Physicians’ Services As the primary gatekeeper for the use of medi- cal procedures, the physician is a key actor in deci- sions bearing on the adoption and use of medical devices. Most diagnostic and therapeutic services must be ordered by a physician or provided under a physicians direction. Although the patient always has the right to refuse services and can re- frain from seeking care in the first place, this course is restricted by consumers’ limited knowl- edge and a medical care system that exhorts that patient to “follow doctor's orders.” The key role of the physician is reinforced by extensive insur- ance coverage, which reduces the patient's eco- nomic incentive to refuse or question services (139). In 1982, physicians received approximately 37 percent of their revenues directly from patients, 35 percent from private insurance, 18 percent from Medicare, almost 5 percent from Medicaid, and the remainder from private philanthropy and other sources of Government support (128). Third-party payers generally pay for covered physicians’ services on a fee-for-service basis. There are two primary approaches to determin- ing levels of payment: the benefit schedule and the fee screen (285). Under the benefit schedule approach, the insurer pays the patient or physi- cian a predetermined fixed amount for each cov- ered service. In private insurance plans, the pa- tient is responsible for paying the difference between the physician's fee and the amount of the bene- fit, as well as any deductibles and coinsurance. The fee-screen approach, used by Blue Shield plans, Medicare, and some Medicaid programs and commercial major medical plans, pays the physician's actual charge (less coinsurance and deductibles) up to some maximum amount that is computed from profiles of the physician's own fees and those of other physicians in the same spe- cialty and region. This fee-screen approach is gen- erally referred to as the usual, customary, and rea- sonable (UCR) approach to payment. Medicare uses a variant of the UCR system called custom- ary, prevailing, and reasonable (CPR). Here, the CPR will refer to the general system of computing a payment rate based on historical and compara- tive profiles of physicians’ fees. Under its CPR system, Medicare pays 80 per- cent of the “reasonable charge”: the lowest of the actual charge, the customary charge, or the pre- vailing charge for a service. The customary charge is the median charge for that service by the doc- tor, and the prevailing charge is the charge below which lies 75 percent of all charges for that serv- ice by doctors in a particular specialty and geo- graphic area. Unless the physician enters into an agreement with the insurer to accept the CPR amount as payment in full (i.e., accepts assign- ment), which occurs in about 50 percent of all claims (113), the patient is responsible for pay- ing the difference between the UCR rate and the physician's billed charge. Beginning in 1976, increases in the Medicare prevailing charge have been restricted to a rate reflecting increases in personal income in the United States and the costs of medical practice. Over time, as physicians’ actual fees meet or ex- ceed the prevailing charge, Medicare's CPR sys- tem is becoming a de facto geographic- and spe- cialty-specific benefit schedule. Thus, the difference between benefit schedules and CPR methods is rapidly becoming a moot point as far as the Medi- care system is concerned. The CPR system tends to put a premium on performance of new procedures for which com- parative screens have not been established. A phy- sician can charge a high fee for a new procedure and have it reviewed for its reasonableness by a medical review committee. After these fees are established and comparative screens are devel- oped, the new procedure often remains highly rewarded relative to old procedures, because there is little financial incentive for physicians to lower prices as time goes on. Thus, devices that allow for the performance of such new procedures should be highly valued by physicians, other things being equal. (Note, though, that new procedures may require a cov- erage decision, which may slow the adoption of such devices by physicians.) Gastroendoscopy is an example of a new device-embodied procedure that was introduced at high fee levels and that is 52 e Federal Policies and the Medical Devices Industry today highly profitable to physicians who perform the procedure in sufficient volume (448). New procedures are typically device-embodied, whereas the “thinking services” provided by phy- sicians, even though they may embody advances in knowledge, are generally incorporated in ex- isting procedure categories, such as the office visit. Hence, the bias toward higher rates of return to new procedures generally represents a bias toward device-embodied procedures relative to “cognitive services.” Schroeder and Showstack analyzed four illus- trative styles of medical practice, ranging from infrequent to frequent use of laboratory tests that can be performed in the office (277). Physicians’ net incomes increase as the intensity of labora- tory procedure use increases. To deal with this problem, it has been suggested that uniform ben- efit or fee schedules should be constructed on a basis other than UCR, perhaps by experts review- ing data on the relative costs of procedures (137, 140). The effect of such a fee schedule on the use of device-specific procedures or the adoption of new ones would, of course, depend on the rela- tive fees actually adopted. Should cognitive serv- ices be valued more highly relative to device- specific services, physicians would, other things being equal, have an incentive to spend relatively more of their patient-care time on them. Payment for Ambulatory Clinical Laboratory Services'? Laboratory equipment, supplies, and reagents represent an important and rapidly advancing area of medical devices. Laboratory testing vol- umes have increased dramatically in the past dec- ade, partly as a result of the development of new tests and automated equipment and partly as a result of third-party payment methods. Between 1972 and 1977, laboratory tests nearly doubled for both hospital and ambulatory care (126). Hos- pital laboratory test costs increased from $2.2 bil- lion to over $4 billion, and out-of-hospital tests increased from 850 to 1,510 tests per 1,000 phy- sician visits (126). During this same period, per capita visits to physicians decreased from 5.0 to 4.8 (126). ?The material presented in this section is based on a background paper prepared for OTA by Foster (120). Payment for clinical laboratory services deliv- ered to hospital inpatients is part of the hospital payment system described above. This section focuses on issues in payment for laboratory serv- ices rendered to ambulatory patients. Laboratory tests are generally ordered by phy- sicians and are commonly offered by three kinds of laboratories: those located in hospitals, those located in physicians’ offices, and those independ- ent of both hospitals and physicians’ offices. In 1977, there were an estimated 7,200 hospital lab- oratories, 50,000 to 80,000 physicians’ office lab- oratories, and an estimated 7,650 independent lab- oratories in the country (226,329,355). The setting in which testing takes place is deter- mined in part by the economics of laboratory testing. As new automated chemical laboratory technologies came to market in the 1960s, econ- omies of scale in test production favored cen- tralized testing in large independent laboratories, whereas more recently the development of sim- ple new tests such as enzyme immunoassays and microprocessor-based equipment has favored de- centralized testing in physicians’ offices. But the methods of third-party payment also affect the profitability of testing in different settings and therefore influence the choice of testing location. Medicare's methods of paying for ambulatory laboratory tests are particularly influential for three reasons: first, Medicare beneficiaries repre- sent a substantial proportion of laboratory test use; second, in many States, Medicaid uses Medi- care’s payment methods to pay for ambulatory laboratory services; and third, physicians tend to make decisions on the location of testing for their practice as a whole, not on a specimen-by-speci- men basis, further increasing the leverage of Medi- care program reimbursement decisions. Medicare's payment method for ambulatory laboratory tests depends both on the setting in which a test is ordered (i.e., whether hospital out- patient department or physician's office) and the setting in which it is performed (hospital, physi- cian’s office, or independent laboratory). Before July 1984, Medicare payments for tests ordered during physician office visits were made on a reasonable-charge basis under Part B, the Supplementary Medical Insurance program. Pay- Ch. 3—Payment Policies for Health Care and Medical Devices ¢ 53 ment for these services was 80 percent of the rea- sonable charge, after the beneficiary had met an annual deductible payment (currently $75). The reasonable charge for a laboratory test was deter- mined by a CPR method of screening claims simi- lar to that applied to physicians’ fees. The rea- sonable charge for a laboratory test, regardless of where it is performed, is the lowest of the five following separate limitations: e the actual charge billed for the service by the physician or laboratory; the customary charge of the laboratory or physician for the test, calculated as the pro- vider’s median charge in the previous year; e the prevailing charge in the locality, com- puted as the 75th percentile of all customary charges for all participating laboratories or physicians; e the lowest charge at which the test is widely and consistently available (currently estab- lished for 12 common laboratory tests; or ® the comparable charge paid by the private insurers that serve as the Medicare carrier. The customary charges of hospitals, physicians’ offices, and independent laboratories, regardless of whether they use automated equipment, were commingled to calculate the prevailing charge in the locality, and all kinds of providers of such services were subject to the same prevailing charge or lowest charge limitation. Note also that this procedure generally resulted in Medicare's pay- ing laboratories at a low rate relative to private insurers. Medicare can pay one of three different entities for ambulatory tests: the beneficiary, the test- ordering physician who has accepted assignment, or the testing laboratory that has accepted assign- ment (42 CFR, sec. 405.251(b)). Until a recent change in the law, if the beneficiary sought reim- bursement, he or she would receive from Medi- care 80 percent of the laboratory's reasonable charge, less any deductible. The party billing the beneficiary (whether it be a physician's office, hos- pital, or independent laboratory) was subject to no limitation on the amount that could be charged the beneficiary, who had to make up the dif- ference. Under this method of payment, the physician was in a unique position of having the power not only to choose whether or not to accept assign- ment and bill Medicare directly, but also whether to perform a test in the office or send the specimen to an independent or hospital laboratory. If the physician accepted assignment, the amount Medi- care would pay depended on the information sup- plied on the physician's claim for reimbursement. If the claim indicated that the test was performed in the office, Medicare would pay the physician 80 percent of the reasonable charge as described above. If the claim indicated that the test was per- formed by an outside laboratory, Medicare would pay the physician only the laboratory’s reason- able charge plus a $3 handling fee. Before July 1984, Medicare reimbursement for tests ordered during hospital outpatient visits was based on 80 percent of the cost of the service to the hospital and 80 percent of the reasonable charge for any physician service provided in con- nection with the test. (The patient was responsi- ble for paying the remaining 20 percent.) Since October 1983, HCFA treated most clinical labora- tory tests performed in hospital laboratories not as physicians’ services but as hospital outpatient services. Consequently, the price was typically based on the cost, not the charge, method. In July 1984, Public Law 98-369 established a new method for setting ambulatory laboratory fees that represents a significant departure from the traditional method described above. For a 3- year period beginning in 1984, Medicare payment for laboratory services will be established at a fixed percent of the prevailing fee level (60 per- cent for physicians’ offices and independent lab- oratories, 62 percent for services to hospital out- patients). After 3 years, a national fee schedule, presumably departing from the prevailing charge, will be developed. The new law expressly forbids physicians from billing for laboratory services unless they are ac- tually performed in the physician's office. Physi- cians who conduct their own tests can still choose whether to accept assignment, but the law con- tains a provision to encourage assignment. When a physician accepts assignment, Medicare reim- 54 e Federal Policies and the Medical Devices Industry bursement will be at 100 percent of the fee sched- ule amount (rather than 80 percent) and the co- insurance and deductible will be waived. Independent laboratories must accept assign- ment, but Medicare will pay 100 percent of the fee schedule and will waive coinsurance and de- ductible requirements. The handling fee (currently $3) will be available to the physician or labora- tory that collects the specimen. Overall, Medicare's payment method for lab- oratory tests encourages physicians to perform tests in their own offices, especially when the ex- pected per-test profit exceeds the $3 handling fee (i.e., when the Medicare payment level plus ad- ditional payment by the patient exceeds per-test costs in physicians’ offices by at least $3). Whether this condition is met depends on the technical costs of performing specific tests and the strength of economies of scale in their production. Tests requiring a heavy fixed investment in cap- ital equipment may be economical only for the highest volume group practices. But performing tests in physicians’ offices eliminates transporta- tion costs required of outside laboratories and the extra costs associated with laboratory licensure standards, to which physicians are not obligated in most States. The recent emergence of simple, inexpensive laboratory equipment and test kits that can be operated at a profit at low volumes has opened up a wide new physicians’ office mar- ket that clinical laboratory equipment manufac- turers are seeking to fill (35). The encouragement of testing in physicians’ of- fices, although an important new market for man- ufacturers, may not be the most rational use of health care resources for two reasons. First, there are situations in which the physician has a finan- cial incentive to select the more costly setting. For example, suppose the fee schedule rate for a test is $9 and the cost of the test performed in an in- dependent laboratory is $4.50 (including trans- portation), while a physician can produce the same test at a cost of $5. Under both the old and new reimbursement methods, the physician has an incentive to produce the test in-house, regard- less of the higher cost. When it is recognized that the physician can refuse assignment on a claim- by-claim basis and charge the patient more than $9, the financial incentive to perform the test in the office appears even stronger. Also, by ex- pressly forbidding physicians from billing for serv- ices provided by independent laboratories, the new law will further strengthen the incentive for testing in physicians’ offices. Second, there is suggestive evidence that tests performed in physicians’ offices may be of lower quality than are tests performed by independent laboratories (132a,183,212). Data from a national proficiency testing program conducted by the American Association of Bioanalysts revealed that physicians’ office laboratories in the program pro- duced substantially less precise and accurate test results than did independent laboratories (132a, 183). However, the introduction of automated laboratory technology may improve physician laboratory performance in the future. Medicare's payment system also encourages hospitals to expand their laboratory services to outpatients and nonhospital patients. The new prospective hospital payment system, which per- tains only to inpatients, creates strong pressures for hospitals to maximize the proportion of their laboratory tests conducted on outpatients in or- der to allocate as many costs as possible to (and reap as high revenues from) this less restricted payment area. And to the extent that hospitals can compete for business with independent lab- oratories, this additional source of revenue will further help offset the laboratory-associated costs. However, Medicare's new laboratory payment system may encourage some hospitals to refer the bulk of their inpatient testing to highly automated independent laboratories with competitive prices in order to reduce inpatient costs. Thus, the role of the hospital laboratory in the ambulatory lab- oratory testing market appears to be undergoing fundamental changes—with the precise outcome unknown at this time. Payment for Medical Devices Used in the Home Medical devices used in the home include a wide range of products—from disposable supplies such as bandaids, incontinence aids, and pregnancy tests, to long-lasting equipment such as wheel- Ch. 3—Payment Policies for Health Care and Medical Devices e 55 chairs and hospital beds. Third-party coverage of a device used in the home depends on specific characteristics of the device and the patient. From the standpoint of payment, four different kinds of medical devices are: ® Self-administered medical devices—devices such as bandages, incontinence aids, ther- mometers, blood pressure monitors, or over- the-counter tests. These products are chosen by consumers, not physicians, and most third-party payers do not cover them. There are some exceptions if the devices are pre- scribed by a physician. ® Durable medical equipment (DME)— equipment that can stand repeated use; is generally not useful in the absence of illness; and is appropriate for use in the home. These devices are generally covered, provided they are prescribed by a physician. ® Home health care devices—devices used in conjunction with health care services ren- dered in the home by health care profes- sionals. Medicare and Medicaid cover these devices, but their coverage by private in- surers varies. ® Home renal dialysis devices—equipment and supplies used to provide home renal dialysis to patients with end-stage renal disease. These devices are covered by Medicare, with sup- plementary coverage provided by some pri- vate insurers. Self-administered medical devices, if ordered without a prescription, are rarely covered by third-party payers; consequently, they can be con- sidered traditional consumer goods and will not be discussed in detail except to note that the lack of insurance coverage for such devices puts them at a disadvantage relative to devices provided by physicians or other professionals. If these devices are ordered by prescription, they are sometimes covered under insurance policies, usually to the same degree that devices provided in a physician's office would be covered. Self-administered devices will be demanded if their purchase price and the convenience they represent is competitive with the out-of-pocket costs and convenience of using alternative devices that are covered by third-party payers. Renal dialysis devices used in the home are unique in that they are covered by a uniform Medicare payment system: Medicare's End Stage Renal Disease (ESRD) program. Since 1972, Medi- care benefits have been available to all patients regardless of age. The effect of the payment sys- tem on the kinds and prices of available dialysis equipment and supplies, as well as on the settings in which they are used, has been profound. A sep- arate case study prepared for this report exam- ines hemodialysis devices in detail (see box E) (260). The two other kinds of devices—durable med- ical equipment and devices provided as part of home health care services—raise some interest- ing issues for Federal payment policy and are dis- cussed in detail below. Payment for Durable Medical Equipment Hospital beds, wheelchairs, oxygen and its related equipment, canes, and crutches are ex- amples of DME. The Inspector General of DHHS has projected total national (public and private) expenditures for DME to reach $1.26 billion to $1.58 billion in fiscal year 1985 (160). In 1982, Medicare outlays for DME were about $310 mil- lion (158), up almost 150 percent from $125 mil- lion in 1979 (333). These estimates do not include durable equip- ment provided to Medicare patients as part of home health services, estimated at about $19 mil- lion in 1982 (158). Table 20 shows the distribu- tion of spending for various types of DME by a. sample of Medicare beneficiaries in 1977. Inter- estingly, oxygen and oxygen equipment alone ac- counted for 46 percent of total expenditures for rental and purchase of DME. Medicare expendi- tures for DME may increase even more with the advent of DRG payment for hospitals. The incen- tive for hospitals to discharge patients early to the home may lead to greater use of DME in the recovery period. DME is a distinct benefit category under Medi- care’s Supplementary Medical Insurance program (Part B of Medicare). Medicare generally covers 80 percent of the “reasonable” charge or cost of 56 e Federal Policies and the Medical Devices Industry Ch. 3—Payment Policies for Health Care and Medical Devices e 57 this equipment, subject to the annual deductible amount. In practice, the reasonable charge is determined by the CPR method described in sec- tions above. The allowed rate of payment for a particular item of DME is the minimum of the DME supplier's actual charge, the supplier's cus- tomary charge (the median of supplier's own past charges) or the prevailing charge, defined as the 75th percentile of all purchase or rental charges for the particular device in the locality during the preceding year.!3 *The DME reimbursement system is currently under scrutiny by HCFA and the General Accounting Office for its effects on users’ decisions whether to purchase or rent equipment (92,156,157,237, 25-406 O - 84 - 5 If the supplier agrees to accept the Medicare rea- sonable charge as payment in full (i.e., accepts assignment), then the Medicare enrollee is liable only for his or her 20-percent coinsurance plus any deductible owed. But if the supplier does not accept this payment, the beneficiary must pay the difference between the reasonable charge and the 333). Uncertainty about the duration of use of DME is inherent in the nature of the service, but Medicare's current system of payment provides inadequate incentives for users to purchase equipment, even when it is fairly clear that such a decision would cost Medicare less than rental. Although the issue has important implications for Medi- care expenditures, it does not influence choices among devices or the overall rate of use of devices in any fundamental way and is not discussed in this report. Table 20.—Durable Medical Equipment (DME) Rental and Purchase Reimbursement Expenditures, by Major Category, All Participating Carriers, 1976 and 19772 1976 1977 Rental Purchase Rental Purchase Category description Dollars Percent Dollars Percent Dollars Percent Dollars Percent Hospital beds and accessories ............... $1,591,925 26.53% $ 520,023 9.85% $ 798,338 19.43% $ 867,895 13.81% Commode chairs, bedpans, urinals, and toilet accessories..................... 232,862 3.88 158,948 3.01 148,765 3.62 218,369 3.47 Canes, crutches, and accessories ............ 31,149 0.52 31,656 0.60 33,919 0.83 24,887 0.40 Traction equipment and accessories .......... 175,114 2.92 77,044 1.46 75,780 1.84 108,429 1.73 Walkers and walking aids. ................... 202,821 3.38 170,110 3.22 151,566 3.69 172,573 2.75 Wheelchairs and accessories ................ 1,091,624 18.19 536,966 10.17 736,903 17.93 644,866 10.26 OXYGEN eee — 0.00 2,598,333 49.21 er 0.00 2,323,585 36.98 Pads and cushions ......................... 147,831 2.46 25,911 0.49 45,628 1.11 91,427 1.45 Miscellaneous DME... ...................... 16,570 0.28 18,077 0.34 188,614 4.59 19,450 0.31 Oxygen therapy equipment .................. 1,963,170 32.72 816,872 15.47 1,183,791 28.81 1,349,534 21.48 Repair/maintenance ......................... 347,758 5.80 40,611 0.77 344,094 8.38 36,201 0.58 Unspecified DME ........................... 199,920 3.33 285,558 5.41 401,552 9.77 426,464 6.79 Total «ooo $6,000,744 100.01% $5,280,109 100.00% $4,108,950 100.00% $6,283,680 100.01% @Data not included from Equiptable Tennessee for 1977 or from Washington Physicians Service from Nov. 1 through Dec. 31, 1977. SOURCE: T. J. Janssen and G. T. Saffran, “Reimbursement for Durable Medical Equipment,” Health Care Finan. Rev. 2(3):94, winter 1981. Aijsnpuj s80iA8Qq [BOIPSN BY} PUB S8101|0d [Biopa- e 8G Ch. 3—Payment Policies for Health Care and Medical Devices ¢ 59 actual price of the equipment. The decision whether to accept assignment rests with the supplier on a case-by-case basis. In addition to being generally inflationary, Medicare's CPR pricing system creates particu- lar problems in localities with only one or a few suppliers of DME. A high-priced supplier with at least 25 percent of the locality’s market for a par- ticular kind of DME can unilaterally determine the prevailing charge and thus manipulate its pay- ment rate (237). The only deterrent to such be- havior is the 20-percent coinsurance rate, which may make some consumers sensitive to the price charged. But in localities with just one or two sup- pliers, this price sensitivity is bound to be low. Some observers have noted the potential im- pact of Medicare's hospital DRG payment system on the suppliers of DME (154). Under DRG pay- ment, hospitals have an incentive to become sup- pliers of services and products that are subject to less restrictive payment. One potential is for these institutions to become DME suppliers. Having a built-in referral base of patients would facilitate this kind of service integration. The net effect of competition from hospitals on DME prices is unknown, but it could conceivably cause price cutting by freestanding suppliers in an attempt to maintain their market share. However, the sensitivity of patients to changes in DME prices may be low because the effective coinsur- ance rate for DME in 1977 was estimated at 26 percent (237). Independent suppliers appear to be concerned about the possible effects of competi- tion from hospitals with a “captive” market (161) and have suggested that Medicare require hospi- tals to provide patients with information on in- dependent suppliers. Payment for Home Health Care Services Home health care services are defined as serv- ices that require professionally trained personnel (e.g., nursing, physical therapy) and are delivered to patients in the home. To some extent, home health care substitutes for institutional care pro- vided in hospitals and nursing homes, but in part it is also a service that substitutes for care that would otherwise be provided by family, friends, or patients themselves. Since medical devices are commonly used in the delivery of these services, the recent rapid growth in the use of home health care services will affect the kinds of devices that will be demanded. Although there are no precise data on histori- cal trends in the total use of home health care serv- ices throughout the country, data are available for use by Medicare and Medicaid beneficiaries. From 1974 to 1982, the number of home health visits to Medicare beneficiaries increased by 247 percent, from 8.1 million visits in 1974 to 28.1 million visits in 1982 (159). In the same period, Medicare reimbursements to home health agen- cies—organizations that provide home health care services—grew from 1.2 to 2.5 percent of total Medicare reimbursements, or $1.2 billion in 1982. Approximately 4 percent of those reimbursements were for equipment, appliances, and nonroutine supplies offered as part of home health care visits (136), and 28 percent can be attributed to non- labor costs (310). Medicaid expenditures for home health services were almost $500 million in 1982 (399). Table 21 estimates national home health care expenditures by source in 1981. Since the data underlying these estimates are imprecise, the table should be considered only as a general descrip- tion of the relative importance of various fund- ing sources. Almost 60 percent of home health care expenditures are paid for directly by patients. Medicare and Medicaid account for another 19 percent of such expenditures, and private insur- Table 21.— Estimated Home Health Care Expenditures and Percent Distribution by Source, 1981 Dollar amount Percent (billions) ot total Patient direct payments ...... $3.8 58.5% Medicare ................... 0.92 13.9 (Federal) ................. 0.3 4.6 (State)... (0.2) (3.1) Other government ........... 0.3 4.6 Private health insurance ..... 1.1b 16.90 Philanthropy ................ 0.1 1.5 Total ..................... $6.5 100.0% aThis is an understatement because it includes approximately one-tenth of expenditures provided through hospital-based home health care services. A proxy was used for expenditures for “home health care The proxy used, reimbursement for “other payment services,’ generally reflects government and patient direct payments for home health care, but may not accurately reflect private health insurance coverage, which is probably much lower than the 16.9 percent indicated in the table. SOURCE: R. M. Gibson and D. R. Waldo, “National Health Expenditures, 1981, Health Care Finan. Rev. 4(1):1-35, September 1982. 60 e Federal Policies and the Medical Devices Industry ance for less than 17 percent. These data are for 1981, before expanded Medicare home health benefits as mandated by the Omnibus Budget Reconciliation Act of 1980 (Public Law 96-499) were implemented. Medicare's share of home health care expenditures may have increased since then. The number of home health agencies has grown dramatically in the past 3 years alone. Table 22 shows the number of Medicare-certified home health agencies by type in 1979, 1981, and 1982. Substantial growth occurred in the number of pro- prietary agencies serving Medicare patients. Part of the reported growth between 1981 and 1982 does not represent development of new agencies but is an artifact of the liberalization of Medicare's policy regarding certification of proprietary agen- cies that went into effect in October 1981 pursuant to the Omnibus Budget Reconciliation Act of 1980. But even between 1979 and 1981, when pro- prietaries were unable to participate in Medicare in certain States, the number of these agencies serving Medicare patients grew by almost 75 percent. Medicare will pay for home health services to patients who are homebound, under the care of a physician, and requiring part-time or intermit- tent skilled nursing care or physical or speech ther- apy. There are no deductibles or coinsurance re- quired of the beneficiary, and since 1980, there are no limits on the number of visits the benefici- ary can receive during any year. Medicare reim- burses home health agencies on a reasonable cost basis, much the same as the Medicare inpatient hospital reimbursement method prior to the in- troduction of DRG payment. In the recent past, attempts to control Medicare outlays for home health services have centered on two strategies: 1) tight control over eligibility for home health care services, and 2) imposition of per-visit limits on rates of reimbursement to home health agencies. To be eligible for home health care benefits, the patient must require “intermittent” skilled nurs- ing care. The definition of skilled nursing care depends on the licensing requirements of the in- dividual States; usually it means a person with a Registered Nurse or Licensed Visiting Nurse or equivalent degree. The definition of “intermittent” has been the major avenue for control. HCFA has recently interpreted it to mean a requirement for up to two or three visits per week and less than 8 hours in any one visit. Daily visits by a skilled nurse are reimbursed only if a physician affirms that such frequent visits will not be necessary for more than 2 or 3 weeks (74). The idea is that if a patient needs daily care, he or she should be in a skilled nursing home, even if the person would prefer to stay at home, because it is less expen- sive (162). Medicare does not provide home health care benefits to patients who receive total parenteral or enteral nutrition therapy at home. But, since 1977, Medicare has covered these services under its prosthetic device benefit (Part B), which cov- ers all nutrients, equipment, and supplies. HCFA has interpreted the prosthetic device benefit as re- quiring the patient to have severe and permanent impairment and as not covering the nursing serv- Table 22.—Medicare-Certified Home Health Agencies by Type of Agency December September December Type of agency 1979 1981 1982 Visiting nurses association ............. 511 513 517 Combination (government/voluntary) ..... 50 55 59 Government ....... 1,274 1,234 1,211 Rehabilitation center based. ............ NAa 11 16 Hospital based ........................ 349 432 507 Skilled nursing home based ............ NAa 10 32 Proprietary ............ i. 165 287 628 Private nonprofit ...................... 443 547 632 Other «oo 66 38 37 @NA indicates information not available; home agencies in these categories were classified as “other” in 1979. SOURCES: 1979 data: U.S. Department of Health and Human Services, Health Care Financing Administration, Office of Research and Demonstration, Medicare: Use of Home Health Services, 1980, prepared by Kathryn D. Barrett, July 1983 draft; 1981, 1982 data: Home Health Line, ‘Changing Face of Medicare Home Health” (table), vol. VIII, p. 28, Feb. 4, 1983. Ch. 3—Payment Policies for Health Care and Medical Devices ¢ 61 Photo credit: American Society for Parenteral and Enternal Nutrition, Inc. This portable parenteral nutrition system, which pumps nutrients directly into the bloodstream, is being used by a woman in her home. Medicare pays for parenteral nutrition therapy provided in the home only for people with permanent impairment. ices, delivery charges, or refrigerator for nutri- ent storage. Some home health agencies have complained that these restrictions shift potential nutrition services away from them to suppliers of Part B services, such as retailers of such medical equipment and supplies, and also discriminate against patients requiring home health care as well as nutrition services (153). (See box F for a de- scription of the parenteral and enteral nutrition market.) Control over rates of reimbursement to home health agencies was initiated in 1981 (310) and tightened again in 1981 and 1982. The control was in the form of limits on per-visit routine costs of home health agencies. At present, all home health agencies are subject to a per-visit limit set at the 75th percentile of costs of freestanding agencies, weighted by the mix of visits made (skilled nurs- ing, physical therapy, home health aids) and the urban or rural location of the agency. The cost of medical equipment, appliances, and supplies that are not routinely furnished in conjunction with patient care visits are not subjected to the limits. The reimbursement limits have several inherent incentives. The most obvious is for the home health agency to “unbundle” its supplies from routine categories to nonroutine categories, which are not subject to payment limits. The second is to substitute nonroutine equipment, appliances or supplies for routine nursing or other services whenever possible. Third, the agency has no in- centive to consider price in decisions to purchase nonroutine items. The ultimate effect of these limits is probably to increase the use and cost of medical devices in home health care. “Medical supplies that are not routinely furnished in conjunc- tion with patient care visits and are directly identifiable services to an individual patient must meet the following criteria: 1) the com- mon and established practice of home health agencies in the area is to charge separately for the item; 2) the agency follows a consist- ent charging practice for both Medicare and non-Medicare patients receiving the item; 3) generally, the item is not frequently furnished to the patient; 4) the costs can be identified and accumulated in a separate cost center; and 5) the item is furnished at the direction of the patients physician and is specifically identified in the plan of treatment (310). 62 e Federal Policies and the Medical Devices Industry Ch. 3—Payment Policies for Health Care and Medical Devices ¢ 63 THE FINANCIAL RELATIONSHIP BETWEEN THE THIRD-PARTY PAYER AND PROVIDERS The vast majority of health care services in the United States are delivered by private providers— hospitals, physicians, and other professionals and institutions—who are organizationally and finan- cially independent of the third-party payer. As discussed above, these providers bill either the pa- tient, the third-party payer, or both and are paid some proportion of their costs or charges, depend- ing on the payment methods and policies of the third-party payer. This fee-for-service system pays providers more when more services are delivered. Except for those services whose level of payment is below their cost,** the provider is financially rewarded by providing more services. Although the third-party payer can attempt to control the use of services through regulatory means, such >There are several reasons why the level of payment might be below the cost of providing a service to a given patient. First, the cost of providing the service might vary randomly around some mean level, thus leading to losses on some patients, which are made up for by profits on others. Second, the service might be a “loss- leader,” deliberately priced low to encourage utilization of other, more profitable services. Third, the provider may be required to offer some services below cost as a condition for providing others to a third-party payer's beneficiaries. as utilization review, the provider has a general incentive to deliver more individually billable services. There are two exceptions to this fiscal independ- ence of payer from provider. First, for health serv- ices that are provided directly by the government in publicly owned and operated facilities, the payer and provider are integrated in the same en- tity. The VA's system of hospitals, nursing homes, and outpatient clinics is an example of an in- tegrated health care system that is relatively closed and publicly funded and operated. Second, a small but growing proportion of the population is enrolled in per capita insurance plans. Public Systems Whether the patterns of use of health care serv- ices and, hence, of the devices on which many of them depend are substantially different in pub- licly operated and budgeted facilities is a matter for empirical investigation. There is some circum- stantial evidence suggesting that the rate of adop- tion of certain new medical devices has been 64 Federal Policies and the Medical Devices Industry slower in VA hospitals than in the civilian health care sector, but differences between public and private administration confound the comparison. VA hospitals adopted CT scanners much more slowly than other hospitals of comparable size. In 1980, almost 85 percent of all community hos- pitals of 500 beds or more had at least one CT scanner, whereas only 25 percent of VA hospi- tals of comparable size had adopted CT scanning (349).%¢ In the remaining hospitals, the VA con- tracted with civilian hospitals for provision of CT procedures. The rate of use of therapeutic apheresis also ap- pears to be substantially lower in VA hospitals than in the civilian sector, although no compari- sons by type of patients treated are available to pursue the reasons for the difference (350). A study conducted in the early 1970s of hospitals’ adoption of respiratory therapy techniques and electronic data processing found that Federal hos- pitals adopted these technologies more widely than non-Federal hospitals, but the study did not "control for hospital size, the population served, and other important differences between Federal and non-Federal hospitals (187). (Federal hospi- tals on average are much larger than non-Federal hospitals.) Per Capita Payment Systems The second exception to the fiscal independence of payer and provider covers a small but grow- ing proportion of the population (5.8 percent in January 1984 (170)) enrolled in health mainte- nance organizations (HMOs). For a fixed per cap- ita payment, HMOs provide comprehensive but specified covered medical services through a defined set of physicians and hospitals (346). An HMO may either employ or contract with physicians to provide the covered services. If the relationship is contractual, it may be on a basis other than sim- ple fee-for-service. Although an HMO may own its hospital, almost all contract with selected hos- pitals and other facilities to provide services to their enrolled members. Since the HMO must compete with other insurers, it has an incentive to keep premiums competitive with them. HMOs 18Most VA medical centers, for example, include chronic care beds, whereas most community hospitals do not. are also organizationally well suited to limiting costs by controlling the use of covered services. There is strong evidence that enrollees of pre- paid group practices, a type of HMO organized around a medical group practice, have lower rates of hospitalization than other plans. In a review of HMO experience, Luft concluded that enrollees in prepaid groups had about 30 percent fewer hos- pital days, mainly because of lower admission rates rather than shorter lengths of stay (198). But studies of HMOs organized around contracts with independent physicians, frequently referred to as individual practice associations (IPAs), do not support the contention that these have lower hospitalization rates when differences among pa- tient characteristics are considered (346). In gen- eral, IPAs and other HMOs appear to have lower rates of surgery than fee-for-service plans (346). The lower rates of hospitalization in prepaid groups would, of course, lower the use of medi- cal supplies and equipment in the hospital. Sur- gical supplies and equipment, in particular, would need to be bought less frequently under an HMO payment system. Of course, to some extent re- ductions in the use of hospital devices may be accompanied by more intensive use of device- embodied procedures during ambulatory care visits. The net effect of these shifts has not been stud- ied, but it is likely that the direct impact of HMOs to date on the medical devices industry or any of its segments is probably small.?” Although the competitive effect of HMOs on the behavior of other private insurers could reduce the rate of use of health services more generally in the commu- nity, particularly in those metropolitan areas where HMOs have a significant share of the in- surance market, there is no convincing evidence that such an effect has occurred (198). This re- sult is not surprising considering that HMOs, as well as other plans, have been operating in an environment where the buyers of health insurance 17As of January 1984, 5.8 percent of the civilian population was enrolled in HMOs, and in 1981, about 84 percent of HMO enrollees were in prepaid group practices (170). If prepaid group practices account for a 30-percent reduction in days of stay per capita, the existence of prepaid group practices is responsible for at most a re- duction of 1.5 percent in total patient days. Ch. 3—Payment Policies for Health Care and Medical Devices ® 65 and medical care are insulated from market pres- sures to be efficient. The appeal of HMOs and other prepaid plans is that they hold promise for more careful assess- ment of all inputs into the production of health care services, including devices. HMOs have in- centives to provide care in the most efficient and cost-effective manner, using the best mix of re- sources to accomplish that purpose. But there are also pitfalls. HMOs have an incentive to enroll healthy members of the population whose medi- cal care is less costly to provide. Such practices also have a financial incentive to provide as few services as possible to their enrollees. As long as HMOs exist in an environment in which they must compete for members, however, the tendency toward underprovision of services may be limited. DISCUSSION AND POLICY OPTIONS This chapter has examined the relationship of third-party payment, particularly Medicare, to the overall size of the medical devices market and the kinds of medical devices that are likely to be bought and used. In the traditional fee-for-service sector of U.S. health care, the decision to cover a particular device and the methods used to de- termine the amount of payment appear to influ- ence the demand for devices. The methods used to determine levels of pay- ment for devices or device-embodied medical serv- ices have influenced their adoption and use in ways that will increase society's cost without ade- quate concern for benefits. In particular, the rea- sonable charge approach used by Medicare for all Part B services creates problems in several areas. With physicians’ services it tends to favor new device-embodied procedures over traditional tech- nologies and office visits, with inadequate regard for their relative cost effectiveness. For laboratory testing, the CPR mechanism tends to encourage laboratory testing in physicians’ offices. And for durable medical equipment, suppliers with a high share of the market may be able to manipulate payment rates. Although cost-based reimbursement of hospi- tals is being largely discarded by Medicare, and may soon disappear for other payers as well, the continuation of cost-based reimbursement of hos- pital capital tends to favor medical equipment over other kinds of resources used in the deliv- ery of hospital services. In addition, the cost-based system continues to apply to Medicare home health services, creating incentives to use medi- cal devices (as well as other inputs to home health services) that may be socially inefficient. Although Medicare has instituted limits on per-visit costs, they do not include nonroutine supplies, equip- ment, and appliances provided as part of a phy- sician’s plan for home health services. Thus, there are additional incentives for home health care to become too device-intensive over time. It appears that the manufacturers of medical devices may be responsive to changes in third- party payment policy, particularly Federal pay- ment policy, in the kinds of devices that are made and the prices at which they are sold. Even in con- centrated markets, such as that for hemodialyzers, manufacturers appear to have been responsive to market pressures by reducing prices or improv- ing products to enhance their productivity (260). The recent introduction of Medicare's DRG pay- ment system may lead to substantial changes in the kinds of devices that are marketed to hospi- tals. The ultimate impact of these changes on the total market for medical devices is, of course, unknown—as are their ultimate effects on the quality and costs of medical care. The problems discussed above can be addressed on a piecemeal basis by altering details of third- party payment methods, or they can be addressed by broader reforms of the payment system. The options discussed in this section begin with those addressing specific issues raised in four areas of payment: clinical laboratory services, home health services, physicians’ services, and hospital serv- ices. Options related to more fundamental changes in the health care payment system are then dis- cussed. 66 ¢ Federal Policies and the Medical Devices Industry Payment for Laboratory Testing Physicians have financial incentives to order and perform clinical laboratory tests in their of- fices. The solution to this situation is the devel- opment of payment methods with neutral finan- cial incentives for physicians to order diagnostic procedures and to select the least costly settings of test performance. Option 1: Mandate that Medicare establish a lab- oratory fee schedule with mandatory assign- ment for all providers. Medicare's new fee schedule for laboratory services lowers Medicare's payment for tests, but it may strengthen physicians’ financial incentives to conduct laboratory tests in their own offices, even when office tests are more costly than tests sent to independent laboratories. A fee schedule system that on the one hand re- quires mandatory assignment of laboratory claims by physicians and on the other allows the physi- cian to bill for services even when they are pro- vided by outside laboratories would give physi- cians a financial incentive to perform their own laboratory tests only when the tests are less costly to perform in the office than in an outside lab- oratory. The fee schedule could be based on the price typically charged by laboratories to physicians. This price is usually competitive, especially in metropolitan areas. This option would eliminate incentives to per- form tests in physicians’ offices when they are more costly than sending them out, but it would not necessarily eliminate the financial incentive that physicians have to increase test ordering. If the physician must accept assignment, whether a test is profitable will depend on the difference between the fee allowed by Medicare and the lowest cost at which the physician can provide the service. Careful and constant attention would need to be given to the relationship between prices of tests and efficient production of laboratory services because some tests will continue to be profitable and others may become profitable as new technologies reduce laboratory costs. Option 2: Mandate that Medicare experiment with other alternatives to the reasonable charge method for clinical laboratory services. A national fee schedule is just one of the alter- natives to the reasonable charge methodology for clinical laboratory services. For example, competi- tive bidding, negotiated rates of payment, and master contracts have been discussed or imple- mented by State Medicaid agencies. At present, there is insufficient evidence to assess which of these or other approaches is the most effective ap- proach to purchasing laboratory services for Medicare beneficiaries. The 1981 Omnibus Budget Reconciliation Act (Public Law 97-35) authorized States to enter into competitive bidding or other similar arrangements to procure laboratory testing for Medicaid popu- lations. A State must demonstrate that laboratory services will be adequate, that selected labora- tories will be Medicare-certified, and that no more than 75 percent of the business of the winning lab- oratory is reimbursed by Medicare and Medicaid. To date, only Nevada has implemented competi- tive bidding for laboratory services (120). California is considering development of a “master contract” with terms spelled out and reim- bursement rates set. The contract would be of- fered to any licensed or certified laboratory wish- ing to provide services to California Medicaid enrollees. HCFA has had under consideration several demonstration projects to test varying methods of laboratory reimbursement. HCFA plans to test four different procurement approaches through demonstration projects: payment rates established by negotiation with laboratories; fee setting by HCFA without negotiation; competitive bidding with laboratories eligible to provide services as long as they agree to accept the price of the win- ning bid; and competitive bidding with only win- ning bidders eligible to provide Medicare testing. Currently, HCFA is awaiting the report of a con- tractor for design of a competitive bidding meth- odology (120). It remains to be seen whether the demonstration will actually be undertaken. The Administration has proposed legislation to authorize the Secretary of Health and Human Ch. 3—Payment Policies for Health Care and Medical Devices ¢ 67 Services to purchase Medicare laboratory serv- ices by competitive bidding, negotiated payment rates, or exclusive contracts with laboratories (S. 643, H. 2576). Because little is known about the feasibility or impact of these approaches, it seems premature to engage in them on a nonexperimen- tal basis. Payment for Devices Used in the Home Medicare reimburses for medical devices used in the home through the durable medical equip- ment benefit (Part B), the prosthetic devices ben- efit (Part B), and the home health services bene- fit (Parts A and B).2® There are several problems in existing payment methods that may affect the kinds of devices that are used and the prices at which they are offered. Moreover, lack of coordi- nation among these benefit categories creates anomalies in payment for different patients using the same devices. Option 3: Mandate that Medicare include in per- visit payment limits on home health services the cost of nonroutine equipment and supplies. Cost-based reimbursement of home health care services creates problems of inflation and inap- propriate use of all inputs, including devices. For this reason, Congress has authorized DHHS to limit per-visit rates of reimbursement for routine services to the 75th percentile of the costs of free- standing agencies (those not affiliated with insti- tutions) in similar circumstances. At present, how- ever, the cost of medical equipment, appliances, and supplies that are not routinely furnished in conjunction with patient care visits are not sub- ject to the the limits. This exclusion creates in- centives for agencies to “unbundle” their supplies from routine categories to nonroutine categories and to substitute nonroutine equipment, appli- 18The Medicare program has two parts: Part A, the Hospital In- surance program; and Part B, the Supplementary Medical Insur- ance plan. Part A's primary purpose is to provide protection against the costs of inpatient hospital care. Other Part A benefits include posthospital extended care services, home health services, and in- patient alcohol detoxification services. Part B services include phy- sician services, outpatient hospital services, outpatient physical ther- apy, and other ambulatory services and supplies, such as prosthetic devices and durable medical equipment. Part B also covers home health services for those Medicare beneficiaries who have only Part B coverage (345). ances, or supplies for routine nursing or other services whenever possible. Moreover, a home health agency has no incentive to consider price in decisions to purchase nonroutine items. Integrating nonroutine items into the per-visit limits would eliminate these problems, but it would also increase the already existing incentives for home health agencies to select as clients pa- tients whose need for such items is relatively low. Without a reliable measure of case severity, the potential for such patient selection strategies would probably be high. Therefore, an important priority for research would be development of a patient classification system for home care simi- lar to the DRG system used for hospitals. Even then, there is the question of whether home health agencies are large enough to spread the risk of enrolling patients with high equipment needs across a large enough pool of patients. Option 4: Encourage Medicare to experiment with alternatives to reasonable charge reimbursement of durable medical equipment (DME). As with other Part B services, the use of rea- sonable charge screens—maximum limits on the amount Medicare will pay based on comparative profiles of suppliers’ actual charges—for DME probably raises the prices paid for such equip- ment. Medicare's CPR pricing system for DME creates particular problems in localities with only one or a few suppliers of DME, where a high- priced supplier with at least 25 percent of the locality’s market for a particular kind of DME can unilaterally determine the prevailing charge and thus manipulate its payment rate. Possible alternatives to the CPR pricing system would be national or regional price ceilings and competitive bidding by suppliers. As yet, there is no experience with either of these approaches, so it is unknown how they would affect the avail- ability or prices of DME. Price ceilings based in the beginning on regional or national average prices and adjusted for general inflation over the years would tend to raise prices charged by low- priced suppliers while at the same time lowering those of high-priced suppliers. It might also re- duce the access of Medicare beneficiaries, particu- larly those with low incomes, to DME if assign- 68 e Federal Policies and the Medical Devices Industry ment rates were to drop as a consequence of the ceilings or if suppliers in high-cost localities were to find it unprofitable to serve Medicare benefi- ciaries. Unless this approach were adopted in conjunc- tion with a requirement that suppliers of DME beneficiaries accept assignment or elimination of the 20-percent coinsurance requirement for those accepting assignment, the drop in assignment rates would cause part of the burden of expenditure to shift from Medicare to the beneficiary. Competitive bidding by suppliers would be most useful in areas with a reasonably large num- ber of potential suppliers. The details of a com- petitive bidding strategy are important in deter- mining the effect on availability and prices of DME. One approach would be a Medicare re- quirement that all DME rentals or purchases in a locality be made through the two or three low- bidding suppliers. This approach would probably be successful in driving down prices in the near term, but it has certain drawbacks. First, the bid- ding would have to be on a product-by-product basis, and it would be impractical to require a ben- eficiary to use a different supplier for each device bought. Second, the approach could lead to a re- duction in the number of suppliers, with conse- quent increases in prices by remaining suppliers in subsequent years. The effect of any of these approaches on the price and availability of DME to Medicare bene- ficiaries could be studied in the context of dem- onstrations or experiments. Option 5: Extend Medicare home health bene- fits to individuals on parenteral or enteral nu- trition. Medicare currently refuses to provide home health care benefits to patients who receive at home total parenteral or enteral nutrition ther- apy—methods of direct feeding through the blood- stream or gut. Since 1977, Medicare has covered these services as a Part B benefit under prosthetic devices. HCFA has interpreted the prosthetic de- vice beriefit as applying only to patients with per- manent impairment and as excluding any nurs- ing services. However, as part of training and adjustment for home parenteral and enteral nu- trition, nursing services may be required. Patients must receive these services at outpatient depart- ments for nursing services to be reimbursed. The effect of this regulation is to limit parenteral and enteral nutrition benefits to ambulatory pa- tients with permanent need for the technology. It might be possible to shift patients out of hos- pitals into home care settings if these restrictions were lifted. However, if home health benefits were extended to patients receiving parenteral and enteral nutrition, the current 20-percent coinsur- ance rate would no longer apply because home health services (Part A) do not entail coinsurance, and Medicare would bear the full burden of ex- penditure. To avoid this added cost to Medicare, Congress could authorize DHHS to maintain the relevant equipment and supplies costs as pros- thetic devices under Part B, while offering home health benefits under Part A. Patients receiving such services would then be required to copay for the Part B portion but not for the home health services. Payment for Physicians’ Services Medicare and some other third parties pay for covered physicians’ services on a reasonable charge basis. These systems, based as they are on pro- files of physicians’ charges, tend to have an in- flationary effect on physicians’ fees because each physician's future payment is tied through the fee screen to currently billed charges. In addition, these systems put a premium on the performance of new procedures for which comparative fee screens have not been established. The physician can charge a high fee for a new procedure and have it reviewed for its reasonableness by a med- ical review committee composed primarily of practicing physicians. After these fees are estab- lished and comparative fee screens are developed, the new procedures remain highly rewarded rela- tive to old procedures. The Federal Government could adopt for Medi- care, Medicaid, and CHAMPUS several options for physician payment to address these problems. Ch. 3—Payment Policies for Health Care and Medical Devices ® 69 Option 6: Mandate that Federal insurance pro- grams adopt fee schedules that change the rela- tive prices of new v. old procedures and device- bound v. cognitive procedures. The objective of developing fee schedules that change relative prices is not to discourage the in- troduction of new devices, but to remove the pres- ent financial incentives to select one procedure over another (239). Implementation of this option would require collection of data on the costs of performing both new and old procedures in order to establish rela- tive prices. It would also require a system for monitoring cost changes in procedures as they dif- fuse into the practice of medicine (140). Moreover, it is not clear that relative costs are the most appropriate basis for relative prices. Prices should reflect the relative values of procedures, but be- cause of present distortions in the pricing system, it would be difficult to identify differences in these relative values. Hence, setting relative fees would require making judgments about technologies, specialties, and classes of medical care because relative fees affect their use. How would relative price schedules be affected by voluntary assignment as now exists under Medicare? Voluntary assignment effectively turns a fee schedule into a benefit schedule. A fee sched- ule limits the amount actually received by the pro- vider, whereas a benefit schedule limits the amount that will be paid by the insurer. Under a fee schedule, the insurer pays only the stated price for a procedure and requires the provider to ac- cept that price as payment in full or not be paid for the service at all. Under Medicaid’s mandatory assignment system, a relative price schedule would be a fee schedule. With voluntary assignment, however, the physician could collect the difference between the billed charge and Medicare's payment from the patient, rendering the payment limit a benefit schedule. To some extent, then, a benefit schedule that paid relatively less for services associated with medical devices and more for cognitive services would result in Medicare patients’ paying a greater share of the costs of medical devices. Since peo- ple generally use fewer services the greater the level of cost-sharing, the relative use of medical devices would be expected to fall somewhat, but the extent of this effect is unknown. Option 7: Mandate that Federal insurance pro- grams pay physicians by episode of illness or by person served rather than by procedures or services delivered. Just as DRG hospital payments provide incen- tives for hospitals to treat each hospital case in the least costly manner possible with the least costly mix of devices and other inputs, payment for ambulatory physicians’ services by the episode or case would offer similar incentives to physi- cians. In particular, the financial incentives to pro- vide more laboratory tests and other device- bound procedures than is cost effective would be eliminated. However, this approach would not only elim- inate financial incentives to perform specific pro- cedures, since each procedure performed would reduce physicians’ net incomes. Whether physi- cians would actually respond to those financial incentives is unknown. Underprovision of labora- tory and other device-bound procedures would be a possibility in some cases and would require monitoring. This option would also require development of new systems of classifying patients according to medical conditions, complaints, or health status. Otherwise, people with serious conditions and higher use rates might gravitate to certain pro- viders and overburden them financially (“adverse selection”), or some providers might try to attract people considered less costly to treat (“cream- skimming”). At present, the technology of patient classification does not appear to be well devel- oped in the ambulatory care area. One way to begin implementing this option would be to focus on physicians’ services to hos- pital inpatients. Physicians could be paid a spe- cific fee based on the patient's diagnostic category for the entire hospital stay, rather than for each inpatient visit. This arrangement would provide financial incentives to reduce the number of phy- sician visits to the hospital and, as a consequence, the number of procedures ordered. However, even this limited use of per-episode physician payment would be difficult to implement soon. First, a 70 e Federal Policies and the Medical Devices Industry classification system appropriate to physicians’ in- puts has not been developed, and the validity of DRGs as a classification system for physicians has not been tested; second, physicians’ claims data are not organized in a way that readily allows esti- mation of the relative use of physician service by inpatients in different diagnoses. The development of adequate patient classifica- tion systems to support payment on a basis other than fee-for-services is expensive, and individual payers have little incentive to support such re- search. As it has in the past, the Federal Govern- ment through HCFA could take the lead in sup- porting research in this area. Hospital Payment Medicare's new DRG payment system estab- lishes a different set of incentives for hospitals. These incentives represent an improvement over the previous cost-based reimbursement system be- cause, unlike the old system, they encourage hos- pitals to treat each inpatient case in the least costly manner possible. Of course, the DRG system is new and hardly complete; further modifications in its administration can be expected. One such modification with particular relevance to medi- cal devices is the treatment of capital costs. The current system leaves capital costs (depreciation and interest!) reimbursed as they are incurred, with no limit on the amount that a hospital can be paid. In conjunction with fixed payment for most other components of inpatient costs, this ap- proach encourages investment in medical equip- ment and facilities relative to personnel and sup- plies, which are controlled. Option 8: Amend the Social Security Act to in- clude payment for capital in DRG payment rates. The fundamental issue under the newly created Medicare DRG payment system is whether a hos- pital’s capital payment should or should not be subject to some kind of externally imposed limit. The current passthrough reimbursement of capi- tal could continue as a permanent feature of DRG 1°Capital cost also includes a payment for return on equity, but only to proprietary hospitals. payment. Alternative methods of capital payment that impose limits on reimbursement fall into three categories: 1) those that establish uniform rates of payment across all hospitals (or all within a class); 2) those that establish hospital-specific limits to capital payment; and 3) those that con- dition payment on approval of capital expendi- ture projects. The uniform payment approach would treat all hospitals alike, regardless of their capital or oper- ating expenditures. Uniform payment could be calculated either as a fixed percentage of the DRG price or as a flat rate per bed. Hospital-specific approaches, on the other hand, would take the hospital's capital or operating costs into account in establishing a level of payment, but limit in- creases in the payment level over time. Thus, for example, capital payments could be limited to a percent of operating costs, so that hospitals with high operating costs would receive a higher capi- tal payment than others; alternatively, the capi- tal payment in any year could be tied to the hos- pital’s actual capital costs (as measured by interest and depreciation) in a base year with adjustments for inflation in subsequent years. If capital payments were controlled through di- rect regulation of capital expenditures, only proj- ects approved by a certificate of need (CON) or other designated agency would be recognized by Medicare for capital payment. Approved projects would then be paid on a cost basis. Areawide or statewide annual capital expenditure limits could be used to establish an upper bound on the value of approved projects. The State of New York is currently considering adoption of such a capital expenditure limit (38). The alternative capital payment methods de- scribed above can be evaluated on the basis of four general criteria: e Efficiency—the extent to which the approach promotes the cost-effective use of hospital devices. e Equity of access to medical technology —the extent to which the method promotes equal access among population groups to capital- embodied medical technology. ® Fairness—the extent to which the method treats all kinds of hospitals alike, neither Ch. 3—Payment Policies for Health Care and Medical Devices ¢ 71 rewarding nor penalizing hospitals for con- ditions outside their control. ® Feasibility —the extent to which the method is administratively workable and politically acceptable. As discussed above, a permanent capital cost passthrough under DRG payment violates the effi- ciency criterion, because it distorts incentives for hospitals to adopt and use capital-embodied de- vices. However, this approach does well on the other three criteria. Its feasibility has been demon- strated through the years. It is inherently fair be- cause all hospitals face the same rules regarding capital payment. Finally, it poses no barriers to equal access to medical technology, although it does nothing to redress current inequities. Any of the three controlled payment methods described are more efficient than passthrough cap- ital payment, because the hospital is encouraged to provide its care at the least possible cost. New medical devices would be judged in terms of their impact on total costs, not just on operating costs. Hospitals would be further encouraged to special- ize and join in plans for regionalization of health services. However, it is difficult to devise a con- trolled payment system that is fair to all hospi- tals. In a uniform payment system, hospitals that in the past have had lower ratios of capital to operating cost would receive more than they had in the past, while those with high ratios would receive less. A uniform rate of payment would also create a difficult and possibly costly transition if hospi- tals that have made major investments in recent years or anticipate them in the near future are not to be unduly penalized. The American Hospital Association has recently proposed a uniform cap- ital payment system that would pay each hospi- tal the higher of cost-based reimbursement or a fixed payment rate during a 10-year phase-in period (8). Anderson and Ginsberg have suggested a less generous transition in which “budget neu- trality” is maintained by gradually reducing the proportion of the capital payment that is a pass- through (14). Tying capital payment to the level of capital costs in a base year or to the hospital's operating costs is efficient but may be unfair. This kind of system tends to reward those hospitals who were most capital-intensive in the past, leaving those with low levels of capitalization forever to receive lower payments. Moreover, it would not work well for hospitals requiring major capital expend- itures in the early years of implementation. Per- haps for these reasons, support for this approach has been limited to movable equipment, which typically has shorter lifetimes and lower variations in asset values among hospitals. Hospital capital has two components: the fixed plant and equipment constructed with the facil- ity (new hospital, addition, renovation), and the movable equipment placed in the facility. All capital-embodied medical devices fall into the movable equipment category. The useful lives of movable equipment are usually relatively short (5 to 10 years) and most, but not all, individual equipment purchases are much smaller than the costs of construction. Therefore, it is possible and perhaps even prudent to consider these two classes of capital separately. Two States, New Jersey and Maryland, have included in their prospective per-case payment systems controls on major movable equipment ex- penditures (345). In the case of Maryland, the hos- pital’s current value of undepreciated equipment in a base year is built into the controlled hospital rates, with adjustments only for inflation in subse- quent years.?° In New Jersey, the amount allowed for major movable equipment is determined by a blend of the hospital's own current value of undepreciated equipment and the average current value of undepreciated equipment in similar hos- pitals in the State. Inclusion of major medical equipment in the DRG payment prices would encourage hospitals to consider the cost of such equipment in deci- sions about the most appropriate mix of resources. It would probably require a transition phase for new (and newly equipped) hospitals, but the length of the transition could be short due to the short useful lives of the equipment in this category. 20Exceptions can be negotiated with the State's Health Services Cost Review Commission. 72 e Federal Policies and the Medical Devices Industry It is difficult to predict the effects of direct reg- ulation of capital expenditures through CON or other agencies. Direct regulation can occur with or without statewide or areawide maximum limits on total capital outlays over a given period, and the effects can be expected to differ between the two. Although there has been much discussion in certain States about establishing actual expendi- ture limits or “pooling” capital, all experience to date has been with CON and section 1122 pro- grams that do not operate with areawide or state- wide limits. The experience with capital expend- itures regulation in the absence of such limits has been disappointing, with most evaluations con- cluding that the level of capital expenditures has not been affected (61,63,247,436). Moreover, the distribution of medical technologies among hos- pitals does not appear to have improved as a re- sult of CON (61). There is no evidence, either theoretical or em- pirical, to suggest that the outcome of an annual limit on the level of capital expenditure process would be either efficient or fair (447). A review of the literature on resource allocation decisions by committees revealed that the ultimate out- comes depend on chance and on the composition of the committee and the procedures governing the decisionmaking process (447). Moreover, the kinds of information needed to make informed tradeoffs among competing capital projects is likely to be unavailable, thus leaving the process even more exposed to political solutions. Regardless of whether or not an areawide limit is applied, direct regulation of capital expenditures is administratively feasible only for large projects —construction and renovation projects and ma- jor new services. The current trend toward high thresholds for capital expenditure controls (453) would probably continue, leaving an ever larger proportion of capital-embodied technology to be controlled in some other way. Systemwide Reforms All of the options discussed above involve spe- cific adjustments to a payment system that has two fundamental problems: first, the more units of service that are offered, the more the provider is paid, resulting in greater use of the medical serv- ices, including devices; and second, the more re- strictive one part of the payment system becomes relative to others, the greater is the incentive to shift the settings of service delivery from the more restrictive to the less restrictive ones. When financial incentives are inconsistent with cost-effective adoption and use, regulatory ap- proaches can be attempted, but they are often un- wieldy. For example, the regulatory process of coverage for medical devices creates differential barriers to the introduction of new devices that have little to do with their effectiveness or cost effectiveness. Despite this fact, the sheer size of the task of individually reviewing each medical device for its efficacy and safety (not to mention cost effectiveness) in each potential use as a pre- condition to coverage argues against the devel- opment of such a coverage process. Instead, the difficulties inherent in the coverage process out- lined in this chapter seem to support the devel- opment of payment methods that create incentives for individual providers or users to make deci- sions that are consistent with the goals of the Medicare program. Option 9: Encourage Medicare to move toward payment for medical care (including devices) on a per capita basis. One remedy for the problems of the current sys- tem may be the adoption of per capita payment, in which a set of defined and reasonably com- prehensive services is offered in exchange for a fixed premium. Under per capita arrangements, such as those offered by HMOs, all resources used to produce health services are subject to the same constraints, and incentives exist to select the least costly mix of resources. Per capita payment has two potential problems, however, which suggest that careful assessment be given to this alternative. First, there is the pos- sibility under these plans that people with the greatest need or demand for medical care will en- ter specific plans and that other plans will selec- tively enroll low users, leading to unequal cost burdens among alternative plans. Varying the amount of the payment by the age or existing health status of the beneficiary would address this Ch. 3—Payment Policies for Health Care and Medical Devices * 73 problem, but it is difficult to identify factors that will be associated with greater medical care need. Second, just as fee-for-service medicine gives pro- viders an incentive to provide too many services, providers of services on a per capita basis would 25-406 O - 84 - 6 have a financial incentive to provide too few. However, competition among plans and the costs of malpractice insurance may limit this risk of underprovision. is Research and Development Policies Related to Medical Devices INTRODUCTION New medical devices arise from a process of re- search and development (R&D)—purposeful ac- tivities requiring the investment of time and other economic resources in the investigation of scien- tific or technical problems. R&D is frequently classified into three phases: ® Basic research—original investigation whose objective is to gain fuller knowledge or un- derstanding of the fundamental aspects of phenomena and of observable facts without specific applications in mind (421). ® Applied research—investigation whose ob- jective is to gain knowledge or understand- ing necessary for determining the means by which a recognized and specific need may be met (421). ¢ Development—systematic use of the knowl- edge or understanding gained from research in the design and development of prototypes and processes (413). Investment in R&D, particularly in develop- ment, is a necessary, but not sufficient, condition for technological progress! in medical devices. Some new devices may result from sudden in- sights, with little developmental work needed; others may require a laborious and slow devel- opment phase with high levels of investment. All new devices (or device improvements) need some level of development and possibly research. Yet there are no guarantees that greater investment in R&D will lead to higher levels of technologi- cal progress in a field. The productivity of R&D depends to a large extent on the present state of scientific knowledge (413) and to some extent on the existence of a “product champion” (413), but "Technological progress is defined here as the continual introduc- tion to practice of new and more useful ways of serving human pur- poses (262). it may also depend on how the R&D is organized: who performs it, who funds it, how funding deci- sions are made, and the social and economic struc- ture in which it occurs. The purpose of this chapter is to examine Fed- eral R&D policy as it relates to medical devices.? As in other areas of Federal policy, questions of R&D policy transcend the medical devices field. Federal stimulation of industrial R&D through di- rect subsidies or indirect policies (e.g., tax pol- icy) has been a national concern (67,70). Simi- larly, Federal support for basic research and training as a long-term national investment in technological change and R&D capacity has been discussed widely in general terms (280) and in terms of biomedical research as a whole (413). This discussion will concern itself neither with the broad issues of R&D policy nor with public policy instruments that cannot be readily targeted to specific fields such as medical devices (e.g., the use of income and corporate tax incentives to stimulate R&D). It is important to note, however, that global R&D strategies may have an impact on the level, directions, and settings of R&D on medical devices that is as great or greater than the impact of R&D strategies directed specifically at medical devices. (App. G contains an analysis of the impact of recent changes in Federal tax pol- icy on medical devices R&D.) To address the specific issues pertaining to R&D for medical devices, the chapter first presents data on expenditures for and performance of medical- device-related R&D. The chapter also analyzes sources of support for medical-device-related R&D. The concluding section of the chapter dis- cusses problems that have been identified and pol- icy options to address them. 2R&D in the Veterans Administration is discussed in ch. 7. 77 78 e Federal Policies and the Medical Devices Industry TRENDS IN MEDICAL DEVICES R&D For two reasons, it is difficult to identify and quantify R&D activities specifically related to medical devices. First, most basic and some ap- plied research lays the scientific foundation for a wide range of future products and processes, including medical devices, without being specifi- cally attributable to a device or even to a class of devices. Second, the R&D data that are pub- lished are either aggregated or classified in a man- ner that is inconsistent with the definition of med- ical devices used in this report. The picture of device-related R&D must be sketched from dis- parate and only partially relevant data sources. Annual estimates of the level of health-related R&D expenditures in the United States are avail- able from the National Institutes of Health (NIH), but these estimates are not broken down by phase of R&D and are not specific to medical devices. In 1980, health R&D totaled an estimated $7.89 billion, of which 28 percent was performed, and 31 percent was funded, by industry (404).3 Annual estimates of R&D conducted by medi- cal device companies are available from the Na- tional Science Foundation (NSF) survey of R&D in industrial firms, but their validity as estimates of industrial R&D on medical devices is somewhat limited. The NSF's estimates of company-wide R&D for firms whose primary line of business is one of the five medical device Standard Industrial Classification (SIC) codes* overestimate industrial R&D on medical devices to the extent that the medical device companies conduct R&D in other product categories and underestimate it to the ex- tent that R&D for medical devices is conducted by firms classified in other SIC codes. Because many medical devices firms are owned by large multiproduct firms, the balance is likely to be 3The NIH estimates of industrial R&D for health are imprecise and probably underestimated due to limitations of the data on which the estimates were based (449). “The five medical devices SIC codes are: 3693 (X-ray and elec- tromedical equipment), 3841 (surgical and medical instruments), 3842 (surgical appliances and supplies), 3843 (dental equipment and sup- plies), and 3851 (ophthalmic goods). See ch. 2 for further informa- tion on the SIC codes. SThree obvious examples are the General Electric Co., with ex- tensive R&D in medical imaging; E. I. du Pont, with R&D in health- related products; and Johnson & Johnson, Inc., a drug company with several device subsidiaries. (Because Census Bureau data are confidential, it is impossible to state with certainty the severity of the classification problem.) toward underestimation of industrial R&D on medical devices. NSF's estimates of company-wide expenditures for applied research and development are broken down into general product categories such as “professional and scientific instruments” and “other electrical machinery equipment and supplies.” These categories are too broad to allow the ex- traction of applied research and development ex- penditures that pertain specifically to medical devices. Basic research expenditures are collected for the company as a whole and are not broken down by product class. These caveats must be recognized in interpret- ing table 23, which presents estimates of indus- trial R&D expenditures aggregated over the five medical devices SIC codes. In the 1974-80 period, industrial R&D expenditures, which include both company and Federal funding, grew at an aver- age annual rate of 16.1 percent in the five medi- cal devices SIC codes, as compared with an an- nual growth rate of 11.7 percent in industry as a whole (422,424). It is also interesting to note that although R&D expenditures for medical de- vices are probably underestimated, in 1980, in- dustrial R&D expenditures for firms in the five medical devices SIC codes were equal to 3 per- cent of the value of such firms’ shipments (see table 23); in industry as a whole, R&D expendi- tures were equal to 2.4 percent of the value of shipments (422,424). The data suggest that the medical devices in- dustry is relatively R&D-intensive. In 1980, for firms in the five medical devices SIC codes, com- pany-sponsored R&D was equal to 2.9 percent of the value of such firms’ shipments; for industry as a whole, company-sponsored R&D expendi- tures amounted to only 1.6 percent of the value of shipments (422,424). For the rate of company investment in basic research, there is little dif- ference between medical devices firms and indus- try as a whole. In 1979, firms in the five medical devices SIC codes reported that 3.7 percent of their company-sponsored R&D was basic re- search, while the figure for industrial firms as a whole was 4.1 percent (422,424). Ch. 4—Research and Development Policies Related to Medical Devices e 79 Table 23.—Industrial R&D in Five SIC Medical Devices Codes? 1974-80 (dollars in thousands) Basic Percentage Applied Percentage Percentage Not Percentage Percentage of Year research of total research of total Development of total identified of total Total shipments 1974... $ 3,635 2.6% $35,650 25.1% $100,361 70.6% $ 2,434 1.7% $142,080 2.8% 1975... NA NA NA NA NA NA NA NA 168,884 2.9 1976... 6,234 3.1 33,046 16.6 90,957 45.8 68,637 34.5 198,874 3.0 1977... 8,406 3.7 65,994 28.8 154,277 67.5 NA NA 228,677 2.8 1978... NA NA NA NA NA NA NA NA 273,794 3.0 1979... 11,272 3.8 67,968 23.3 188,690 64.7 23,821 8.2 291,751 2.8 1980... NA NA NA NA NA NA NA NA 348,707 3.0 NA indicates information not available because of issues of confidentiality. aThe five Standard Industrial Classification (SIC) code medical devices categories are: SIC 3693: X-ray and electromedical equipment SIC 3841: Surgical and medical instruments SIC 3842: Surgical appliances and supplies SIC 3843: Dental equipment and supplies SIC 3851: Ophthalmic goods SOURCES: U.S. Department of Commerce, Bureau of Industrial Economics, 1983 U.S. Industrial Outlook, Washington, DC, January 1983; U.S. National Science Founda- tion, “Survey of Industrial Research and Development,” conducted by the U.S. Bureau of the Census, 1982. SOURCES OF SUPPORT FOR MEDICAL-DEVICE-RELATED R&D R&D for medical devices takes place in numer- ous settings—private companies, hospitals, and university and government laboratories. The sources of support for these activities are highly varied. It is impossible to isolate the sources of funding of medical-device-related R&D performed in academic or government laboratories from those for other health or general R&D, but data are available on the sources of funding of medi- cal devices R&D conducted in industry.¢ Table 24 shows the sources of support for in- dustrial R&D in the five SIC medical devices codes. The level of support from NIH and other Federal agencies is substantially lower for industrial R&D in these SIC codes than it is for industrial R&D as a whole. In 1980, the Federal Government funded less than 3 percent of the R&D conducted by firms in these SIC codes, compared with 29 percent of R&D conducted by industry as a whole (422). Federal Support for R&D on Medical Devices The Federal Government supports over 52 per- cent of total health R&D, most of it (70 percent) through grants and contracts from NIH (404). Table 25 shows the distribution of R&D grants and contracts awarded by NIH in fiscal year 1982. The limitations of the NSF industrial R&D survey apply in in- terpreting these data, however. Table 24.—Sources of Support for Industrial R&D in Five SIC Medical Devices Codes? 1974-80 Percent Total change in industrial company- R&D Federal Company sponsored Year (thousands of dollars) R&D 1974... .. $142,080 $3,635 $138,445 — 1975. .... 168,884 4,878 164,006 18.5% 1976... .. 198,874 5,464 193,410 17.9 1977..... 228,677 5,727 222,950 15.3 1978. .... 273,794 5,623 269,171 20.7 1979. .... 291,751 4,788 286,963 6.6 1980... .. 348,707 7,125 341,582 19.0 The five SIC codes are the same as those listed in table 23. SOURCES: U.S. Department of Commerce, Bureau of Industrial Economics, 1983 U.S. Industrial Outlook, Washington, DC, January 1983; U.S. National Science Foundation, “Survey of Industrial Research and Develop- ment,” conducted by the U.S. Bureau of the Census, 1982. Industry received approximately 6 percent of total NIH grants and contracts for that year. (Of course, these grants and contracts encompass much more than the development of medical devices, includ- ing some basic research, drug and biotechnology development, and procurement of items such as research laboratory equipment.) Despite the small proportion of NIH funds that goes to industry, NIH and other agencies’ support for R&D in specific medical device areas is prob- ably sizable in absolute terms. The National In- stitute for Handicapped Research's Rehabilitation Technology program, for example, administers a $9 million annual program of grants and con- 80 e Federal Policies and the Medical Devices Industry Table 25.—R&D Grants and Contracts Awarded by the National Institutes of Health (NIH), Fiscal Year 1982 Total amount Percentage of Performing institution (thousands of dollars) total Domestic institutions ....................... $2,709,248 99% Nonprofit... iii 2,558,010 94 Higher education. ...................... 2,025,822 74 Medical schools ..................... 1,412,540 52 Government ........ 40,656 1 Federal ............................. 2,083 0 Research institutes. ................ 470 0 Hospitals... 404 0 Other ....... 1,209 0 Stateand local ....................... 38,574 1 Research institutes. ................ 1,774 0 Hospitals. ........... coo iii... 26,362 1 Other... 10,438 0 Other nonprofit ...................... 491,531 18 Research institutes. ................ 275,575 10 Hospitals... .............oiiiin... 163,188 6 Other «o.oo 52,768 2 Profit... 151,238 6 Foreign institutions ........................ 22,820 1 Total. ooo $2,732,068 100%:2 apercentage may not sum to 100 because of rounding errors. SOURCE: U.S. Department of Health and Human Services, National Institutes of Health, Office of Program Planning and Evalua- tion and the Division of Research Grants, NIH Data Book 1983, Washington, DC, June 1983, table 17. tracts to 18 centers engaged in applied research and development of rehabilitative devices (299). NIH's critical role in supporting the development of renal dialysis technology is described in box G. A recent analysis of NIH, NSF, and Department of Energy grants and contracts active as of May 1983 revealed that almost $50 million was related to diagnostic imaging (460). This medical imag- ing R&D was scattered throughout the institutes and agencies and covered a wide assortment of subjects including not only development or refine- ment of new imaging devices, but the use of imag- ing techniques to enhance understanding of dis- ease processes. A high proportion of these grants went to academic and other nonprofit institutions, - and therefore supplemented the R&D on medi- cal imaging conducted by industry. NIH funding in the medical imaging area has, in retrospect, had important impacts on the later development of commercial imaging devices. Box H presents the history of Federal funding for research on nuclear magnetic resonance (NMR) imaging. Private Sources of Funds for R&D on Medical Devices How do medical device firms go about financ- ing the R&D that is not supported by direct grants and contracts? Firms have two potential sources of financing: retained earnings and the financial capital markets. If funds are sought from exter- nal sources, they may be generated either through debt or equity instruments. Tables 26, 27, and 28 present data on the sources of financial capital to firms in three Internal Revenue Service (IRS) in- dustry categories: ® optical, medical, and ophthalmic goods (IRS 3845); ® other electrical (including but not limited to X-ray and electromedical devices) (IRS 3698); and ¢ all manufacturing (IRS 40). These industry classifications include a substan- tial number of firms not engaged in the produc- tion of medical devices, and the data pertain to Ch. 4—Research and Development Policies Related to Medical Devices ¢ 81 the financing of all activities in these fields, not just the financing of R&D and innovation. Con- sequently, the interpretation must proceed with caution. Table 26 shows that in 1980, external equity became a very important source of financing for small firms in the optical, medical, and ophthal- mic goods category. Retained earnings have con- sistently been less important to firms in this cate- gory than they are to manufacturing firms as a whole. The shift by small firms in the optical, medical, and ophthalmic goods category toward external equity may be the result of the infusion of large amounts of venture capital into new com- panies in this area in 1979. Notice also that small optical, medical, and ophthalmic goods com- panies depend to a greater extent on all forms of external financing than do large firms in the same industry. The role of venture capital in financing innova- tion in general and new medical devices in par- ticular has increased dramatically since 1978. Ven- ture capitalists are investors who specialize in providing financial capital to small and, some- times, new firms. From 1969 to 1977, the total venture capital pool in the United States remained virtually unchanged, at the level of about $2.5 bil- lion to $3 billion (190). Since then, however, the total venture capital pool has increased sharply, reaching between $3.5 billion and $4 billion in 1979 (441), $5.8 billion in 1981 (442), and an esti- mated $7.5 billion as of December 1982 (440). 82 e Federal Policies and the Medical Devices Industry Ch. 4—Research and Development Policies Related to Medical Devices © 83 Table 26.— Sources of Financial Capital to Firms in IRS Category 3845: Optical, Medical, and Ophthalmic Goods, 1976-80 Asset size class (000s) Asset size class (000s) Ratio $1-$5,000 $5,000+ Ratio $1-$5,000 $5,000+ External equity to assets 1978 o.oo Cee 0.20 0.16 1980 ©. 0.38 0.18 1977 ........ ee 0.20 0.14 1979 o.oo 0.16 0.19 1976 ....... Ce 0.12 0.13 1978 ... Ce 0.23 0.18 Short-term debt to assets 1977 ... FR 0.24 0.20 1980 .......... FRU 0.20 0.17 1976 .... FR 0.26 0.23 1979 ..... FE 0.24 0.13 Retained earnings to assets 1978 Cee 0.22 0.16 1980 oii 0.08 0.35 1977 oo Cee 0.17 0.17 1979 os 0.16 0.37 1976 .......... ee 0.20 0.15 1978 0.14 0.39 Trade debt to assets 1977 oo... ea 0.21 0.40 1980 ........ 0.18 0.17 1976 «oie 0.26 0.40 1979 LL. Ce 0.13 0.15 Long-term debt to assets 1978 ......... Ce 0.17 0.12 1980 «oii 0.14 0.13 1977 oo 0.13 0.09 1979 0.27 0.17 1976 o.oo 0.18 0.09 SOURCE: U.S. Department of the Treasury, Internal Revenue Service, Sourcebook of Statistics of Income, for years 1976-80, as cited in (26). Variability in the amount of venture capital in Recent changes have led to a resurgence in the the United States is influenced by many factors, United States in the supply of venture capital. including sensitivity to general variables in the Especially important to the supply of venture cap- overall economy (e.g., interest rates and infla- ital have been decreases in the rate at which long- tion), changes in capital gains tax laws, and changes term capital gains are taxed. In 1978, the rate of in pension fund investment rules. taxation was reduced substantially; more recently, 84 Federal Policies and the Medical Devices Industry Table 27.—Sources of Financial Capital to Firms in IRS Category 3698: Other Electrical, 1976-80 Asset size class (000s) Ratio $1-$5,000 $5,000-$25,000 $25,000-$100,000 $100,000 + External equity to assets 1980 . 0.16 0.18 0.14 0.09 1979 0.12 0.14 0.15 0.10 1978 0.20 0.17 0.15 0.12 1977 0.22 0.18 0.14 0.13 1976 0.16 0.23 0.19 0.13 Retained earnings to assets 1980 «oo 0.16 0.33 0.48 0.22 1979 0.27 0.39 0.42 0.23 1978 0.22 0.37 0.48 0.25 1977 0.19 0.40 0.47 0.25 1976 oo 0.29 0.35 0.45 0.25 Long-term debt to assets 1980 «o.oo 0.18 0.14 0.13 0.27 1979 0.13 0.13 0.17 0.28 1978 0.14 0.14 0.13 0.27 1977 0.14 0.12 0.13 0.24 1976 0.11 0.13 0.15 0.28 Short-term debt to assets 1980 «oo 0.32 0.21 0.15 0.30 1979 0.25 0.18 0.16 0.27 1978 0.22 0.19 0.16 0.25 1977 0.22 0.18 0.16 0.26 1976 0.22 0.18 0.13 0.23 Trade debt to assets 1980 o.oo 0.19 0.16 0.10 0.12 1979 0.19 0.14 0.10 0.12 1978 0.20 0.13 0.10 0.13 1977 0.21 0.12 0.10 0.12 1976 0.20 0.11 0.09 0.11 SOURCE: U.S. Department of the Treasury, Internal Revenue Service, Sourcebook of Statistics of Income, for years 1976-80, as cited in (26). the Economic Recovery Act of 1981 established the long-term capital gains tax rate at 20 percent for individuals and 28 percent for corporations, making venture investments more attractive than they were under the pre-1978 rate of 49 percent. Also, in 1979, pension fund regulations of the Employee Retirement Income Security Act were interpreted as allowing some pension fund money to flow into venture capital investments. The results of these changes are evident in data presented in table 29, which shows capital com- mitments to private venture capital funds for the years 1978 to 1982. Not only have the total an- nual outlays of venture capital funds increased as a whole, but also the amount available from pen- sion funds has grown dramatically since 1979: in 1982, pension funds represented one-third of the new capital commitments to private venture cap- ital firms (443). In 1981, venture capital investments in medi- cal and health-related products and services con- stituted about 6 percent of investments made in organized venture capital markets (26). Table 30 shows the 1982 distribution of venture capital in- vestments by stage of investment in four prod- uct categories: medical imaging, other medical products, industrial products, and electronics. The two medical devices categories—medical imaging and other medical products—show a rela- tively high proportion of investments in early stages, although in medical devices, as in other fields, the organized venture capital market ap- pears to invest negligible amounts at the earliest (seed money) stage of development. The relatively important role of venture capital firms in financ- ing the startup of new medical device firms sug- gests that investors have been more likely to take greater risks in this field than they have in other Ch. 4—Research and Development Policies Related to Medical Devices ¢ 85 Table 28.—Sources of Financial Capital to Firms in IRS Category 40: All Manufacturing, 1976-80 Asset size class (000s) Ratio $1-$500 $5,000-$25,000 $25,000-$100,000 $100,000+ External equity to assets 1980 «oa 0.13 0.13 0.16 0.16 1979 0.13 0.12 0.16 0.16 1978 0.14 0.13 0.17 0.17 1977 0.18 0.15 0.18 0.17 1976 0.16 0.16 0.19 0.18 Retained earnings to assets 1980 «o.oo 0.29 0.33 0.33 0.28 1979 0.30 0.34 0.33 0.29 1978 0.28 0.35 0.34 0.30 1977 0.28 0.36 0.34 0.30 1976 0.29 0.35 0.34 0.28 Long-term debt to assets 1980 .... 0.18 0.18 0.28 0.25 1979 0.18 0.18 0.20 0.24 1978 0.17 0.16 0.20 0.24 1977 0.17 0.17 0.21 0.25 1976 0.16 0.17 0.20 0.26 Short-term debt to assets 1980 ... 0.21 0.21 0.19 0.19 1979 0.21 0.21 0.19 0.18 1978 0.21 0.21 0.18 0.17 1977 0.21 0.19 0.17 0.16 1976 oo 0.20 0.19 0.17 0.15 Trade debt to assets 1980 .. 0.18 0.15 0.12 0.12 1979 0.19 0.15 0.12 0.13 1978 0.19 0.15 0.12 0.12 1977 0.18 0.14 0.11 0.12 1976 «oo 0.19 0.13 0.10 0.12 SOURCE: U.S. Department of the Treasury, Internal Revenue Service, Sourcebook of Statistics of Income, for years 1976-80, as cited in (26). Table 29.—Capital Commitments to Independent Private Venture Capital Funds, 1979-82 1978 1979 1980 1981 1982 Total capital committed (dollars in millions): Corporations ........... $22 $28 $127 $142 § 175 Endowments and foundations .......... 19 17 92 102 96 Foreign investors ....... 38 26 55 90 188 Individuals and families . . 70 39 102 201 290 Insurance companies . . .. 35 7 88 132 200 Pension funds .......... 32 53 197 200 474 Total... $216 $170 $661 $867 $1,423 Percentage of total capital committed: Corporations ........... 10% 17% 19% 17% 12% Endowments and foundations .......... 9 10 14 12 7 Foreign investors ....... 18 15 8 10 13 Individuals and families . . 32 23 16 23 21 Insurance companies . ... 16 4 13 15 14 Pension funds .......... 15 31 30 28 33 Total ................ 100% 100% 100% 100% 100% SOURCE: Venture Economics, Wellesley Hills, MA, “Venture Capital Investment in the Medical Health Care Field,’ contract report prepared for the Office of Technology Assessment, August 1983. See app. F for a description of the Venture Economics database from which these data were derived. 86 e Federal Policies and the Medical Devices Industry Table 30.—Percentage of Types of Venture Capital Financing in Medical Devices and Other Fields, 19822 Other medical Type of financing Medical imaging products Industrial products Electronics Seed MONBY «vite ieee eee 0% 1% 1% 1% Startup and first stage .................... 57 56 29 35 Expansion... 43 38 37 58 Leveraged buyouts and acquisitions ......... 0 1 27 1 Other... 0 4 6 5 33ee app. F for a description of the Venture Economics database from which this table is derived. SOURCE: Venture Economics, Wellesley Hills, MA, “Venture Capital Investment in the Medical Health Care Field,” contract report prepared for the Office of Technology Assessment, August 1983. fields, even in a traditionally high-technology product category such as electronics. Yet, these data also suggest that small and new firms seek- ing seed money must frequently look to their owners’ and friends’ contributions of both time and money. See box I for an example. THE SMALL BUSINESS INNOVATION RESEARCH PROGRAM The Small Business Innovation Development Act (Public Law 97-219), enacted into law in 1982, requires each Federal agency whose extramural R&D obligations exceed $100 million to set aside a small percentage’ for R&D grants or contracts with small businesses. NIH's Small Business In- novation Research (SBIR) budget amounted to $5.6 million in fiscal year 1983 and $8.2 million in fiscal year 1984.% The awards are made in three phases: Phase I involves small awards of 6 months’ duration for proving the scientific and technical feasibility of new ideas; Phase II involves further development of these ideas with the addition of a plan to acquire non-Federal venture capital in the subsequent phase; and Phase III involves only non-Federal capital committed to pursuit of com- mercial applications (but Federal involvement may be in the form of agreements to purchase products). Each agency may determine the categories of projects within its SBIR program and has control over the size of the maximum award in each phase, the amount of sharing of R&D expenses required of awardees, and the methods and pro- cedures used to solicit and select among proposals. Because the SBIR program is specifically targeted to ideas with commercial promise, the grant awards "The percentage increases from 0.2 in fiscal year 1983 to 1.25 within 4 years. !NIH actually expended $7.3 million in fiscal year 1983 (425). are generally skewed toward applied research and development and away from basic research. The NIH SBIR program made its first Phase I awards in October 1983 in the form of grants of $50,000 in total costs or less. NIH required grantees to commit to sharing in the costs of the research and will pay no profit or fee in addition to costs. An analysis by OTA of NIH SBIR grant applica- tions and awards revealed that an estimated 42 percent of the SBIR applications responding to the first solicitation were for medical devices (see table 31). No significant differences were found in the ratio of awards to proposals between medical devices and other types of research. It is premature to evaluate the effectiveness of the SBIR program on small business innovation in medical devices. Although it is clear that there has been a reallocation of research dollars from other R&D programs within NIH to the SBIR ini- tiative, it is unknown to what extent the dollars have been shifted from research funds that would have gone to academic and nonprofit institutions or from research funds that would have gone to industry anyway. Furthermore, if the shift oc- curred within industry, it is unknown at this time to what extent it represents a net transfer of R&D funds from large firms to small firms or simply a net redistribution of Federal funds among small firms. Ch. 4—Research and Development Policies Related to Medical Devices o 87 88 e Federal Policies and the Medical Devices Industry Table 31.—Analysis of Applications for Small Business Innovation Research (SBIR) Grants, National Institutes of Health, 1983? ] Medical All Biotechnology devices other applications applications® applications? Percentage of total grant applications ........ 6% 42% 52% Percentage of applications receiving awards . . . 21% 23% 18% aSee app. E for estimation methods. bProposals for R&D on medical devices and other technologies using biotechnology. CProposals for R&D on medical devices not using biotechnology. dproposals for R&D on technologies that neither involve the use of biotechnology nor are medical devices. SOURCE: Office of Technology Assessment. Implementation of the SBIR program may also affect the productivity of the SBIR program in stimulating development of new medical devices. One issue is whether or not the program stimu- lates those with the best ideas from a commer- cial perspective to submit grants. It is interesting to note that in fiscal year 1983, the Department of Health and Human Services (DHHS) (mainly NIH) had the lowest ratio of proposals to awards— six to one—of all Federal agencies. The average ratio of proposals to awards for Government as a whole was 11 to 1 (425). Implementation strat- egies, including the choice of topics included in the Public Health Service solicitation, the meth- ods used to distribute information on the SBIR program to small businesses, and policies regard- ing cost-sharing are likely to have influenced the proposal rates. FEDERAL SUPPORT FOR ORPHAN DEVICES The Federal Government has recently been charged with the responsibility of identifying and promoting “orphan products,” including both drugs and medical devices. The Orphan Drug Act (1983, Public Law 97-414) defines orphan prod- ucts as drugs and devices for rare diseases or con- ditions. A rare disease or condition is further defined in the act as one that occurs so infre- quently that there is no reasonable expectation that the cost of developing or making the prod- uct for such a condition can be recovered from sales of the device. In the case of drugs, the 1983 act authorizes the Secretary of Health and Human Services to pro- vide four kinds of support for those that have been found to be orphans: ® a 50-percent tax credit on all clinical testing expenses associated with the drug, ® award of an exclusive 7-year right to mar- ket a drug that is unpatentable (through the new drug approval authority of the Food and Drug Administration (FDA)), e technical assistance in the development of clinical testing protocols, and e award of grants and contracts for clinical testing expenses associated with an orphan drug. (FDA budgeted $500,000 for this func- tion in fiscal year 1983 and $1 million in 1984 (116).) These benefits are not available to devices. The 1983 law also established an Orphan Prod- ucts Board, with responsibility to “promote the development of drugs and devices for rare diseases or conditions . . .,” but its specific functions relate to drugs alone. Thus, the support of orphan devices under the new law is largely a conception rather than a reality. Recently, however, NIH has become active in supporting R&D on orphan devices. For example, the National Institute of Neurological and Communicative Disorders and Stroke issued a request early in 1984 for proposals to develop orphan products including drugs, biologicals, and devices (403). The definition of an orphan device as stated in the 1983 law and in most discussions of the issue Ch. 4—Research and Development Policies Related to Medical Devices ® 89 (115,405) is inadequate because it fails to differen- tiate between products that are prohibitively costly but not particularly valuable from those that are both costly and valuable. Ideally, a de- vice should be considered an orphan when it can be shown to be: e very valuable to potential users, particularly in relation to the cost of development, pro- duction, and distribution; and ® so costly to develop, produce, and distrib- ute that it would be impossible or inequita- ble to expect potential users to pay a price that would allow producers to recover these costs. To take an extreme example, a lifesaving de- vice whose cost per patient is $100,000 would be likely to meet the ideal criteria for an orphan de- vice, whereas a $100,000 per-patient device that improves the quality of life a bit for only a frac- tion of those who use it probably would not. Products for rare diseases or conditions fre- quently (but not always) meet the aforementioned criteria for an orphan device, because a large part of the cost of R&D and marketing is fixed regard- less of the number of units actually sold. With fewer potential users over which these costs can be spread, the price at which the device would have to be sold is likely to be prohibitive. How- ever, a product for a rare disease that is not par- ticularly valuable to users in relation to its costs would not meet the two criteria above, though it would fall into the definition in the act. There may also be products for relatively com- mon diseases whose costs are still high relative to patients’ abilities to pay for them. See box J for a discussion of wheelchairs. Health insurance, developed as a response to the disparity between the cost of services and pa- tients’ abilities to pay for them, complicates mat- ters even further. Third-party payment, which spreads the burden of payment across a broad pool of individuals, is a mechanism for render- ing previously orphaned services and products af- fordable. Indeed, because health insurance gen- erally reduces patients’ out-of-pocket costs for health care services, a device whose cost would normally be prohibitive may have an effective price well below that level. For example, coronary 25-406 O - 84 - 7 artery bypass graft surgery and its related care were estimated to cost approximately $15,000 to $20,000 in 1981 (454). Third parties have paid for a very large share of these costs, and in 1982, ap- proximately 170,000 bypass operations were per- formed (401). Health insurance also forces a redefinition of the market, because insurers’ decisions about the coverage of a device and, if covered, the appro- priate level of payment become major determi- nants of patients’ and providers’ abilities to pay for it. If a service is not covered by health insur- ance, it may be orphaned; covered and paid for generously, it is not. Thus, the definition of an orphan device is in- extricably linked to the policies of third-party pay- ers. Whereas drugs, particularly those prescribed for use outside of hospitals and other institutions, are poorly covered by health insurance plans (in- surance paid only 26 percent of total U.S. expend- itures for outpatient prescribed medicines in 1977 (180)), and may therefore occasionally be pro- hibitively costly to potential users, expensive devices are, with exceptions, in a more favorable position. Devices used for diagnosis or therapy in hospitals, physicians offices, and the home are generally covered by public and private health in- surers. Coinsurance requirements usually follow those for other services provided in the same setting. For example, diagnostic laboratory tests provided as part of the physician's office visit typically have the same coinsurance rate (say, 20 percent) as is applied to the physician's own service. An example of the difference that insurance payment can make in the definition of an orphan is the recent characterization of an immunoassay test for testicular cancer as an orphan by FDA (205). The test is considered an orphan device be- cause the prevalence of testicular cancer in the United States is less than 200,000 (116). Yet this test will probably be covered by third-party pay- ers as a diagnostic service; so it is questionable whether it actually requires special development assistance.’ FDA has not provided substantial assistance to the developers of the test (116). 90 e Federal Policies and the Medical Devices Industry Thus, while insurance coverage for the use of * rehabilitative devices, which are often poorly diagnostic and therapeutic devices is not complete, covered under private and public third-party it is generally much higher than for outpatient payment plans (352); and drugs. Exceptions to this general rule are: ® devices subject to restrictive third-party pay- ® preventive devices (e.g., screening tests, ment limits (e.g., some hospital devices under home self-testing kits), which are less fre- Medicare's per-case pricing for inpatient hos- quently covered under health insurance plans; pital care). Ch. 4—Research and Development Policies Related to Medical Devices © 91 Even in these categories, however, most devices ficiently low price, a large enough market may will not meet the ideal definition of an orphan. still exist despite poor coverage by third parties. If they can be developed and distributed at a suf- STATE AND LOCAL INITIATIVES RELATED TO R&D FOR MEDICAL DEVICES States have increasingly looked to R&D-inten- sive industries such as medical devices for eco- nomic development opportunities. A recent census of State government initiatives for high-technol- ogy development conducted by OTA identified 38 programs in 22 States with “dedicated” pro- grams of high-technology development (353). In addition, OTA identified 15 “high-technology education” initiatives, undertaken in conjunction with State universities and dedicated to provid- ing to inventors and entrepreneurs the skills they need to create firms that will develop or commer- cialize emerging technologies. Only a few of these programs actually provided product development assistance or laboratory or office space for new and growing businesses. Perhaps the program most directly relevant to medical devices is the Health-Care Instrument and Device Institute (HIDI) at the State University of New York at Buffalo, which has been designated by the State of New York as a State-supported center to facilitate direct interface between aca- demic institutions and the needs of industry (see box K). Although the HIDI program has several missions, an important one is to put into prac- tice ideas generated by inventors in the univer- sity community (113). Another popular initiative is the establishment of a research or science park on or adjacent to a university campus. These parks are often en- couraged by State or local tax incentives, but many universities have also seen the advantage of encouraging this type of development. In gen- eral, these and other university-based initiatives are seen as a way of providing consulting oppor- tunities for faculty, employment opportunities for students, and enhanced research funding for the university. Rensselaer Polytechnic Institute, for example, has provided incubator space for en- trepreneurs who need assistance to start a busi- 92 e Federal Policies and the Medical Devices Industry ness (354). Several other universities also provide incubator space for students, including Georgia Tech, Carnegie-Mellon University, Massachusetts Institute of Technology, and the University of Missouri (which also provides commercialization assistance to students.) While some of these centers also assist qualifying small businesses, their ma- jor emphasis is on the enterprising student (354). University-based programs such as these have been criticized for drawing faculty away from the conduct of more basic research in favor of applied research and development. There is also the re- lated issue of maintaining free and open commu- nication within the research community. Suc- cessful commercialization requires shielding a potential product from a firm's competitors, as well as obtaining proprietary rights to the inven- tion. To some extent, these requirements conflict with the ideal of freedom of expression in aca- demic environments. Nor has it been documented that the resources provided by university-based centers are addressing the specific barriers to com- mercialization faced by small or new firms. Since most of these projects are relatively new, it is not possible at this time to evaluate their effects either on innovation or on the quality and quantity of basic research. DISCUSSION AND POLICY OPTIONS Is the current level of Federal and industry sup- port for R&D related to medical devices adequate? Federal support for industrial R&D can be viewed as supplementing private firms’ activities in ways that advance the public good. Federal support is justified when private firms are not likely to engage in as much R&D as is socially desirable. Basic research has long been recognized as be- ing particularly subject to underfunding by pri- vate firms (56,228,230). To be efficient, basic re- search should embody as few constraints as possible on research directions and be subject to wide dis- closure of research results. These conditions con- flict with the ability of private firms to reap the full benefits of their investment in basic research (230). Hence, private firms are likely to under- invest in basic research, and Federal support may be necessary. As R&D projects are more closely targeted to products or processes with commercial potential, however, the argument in favor of Federal sup- port becomes weaker. The private medical device firm is likely to be able to appropriate more fully the benefits of its investment in R&D the closer the project is to a commercializable device. And as research becomes more targeted and specific to a device, the societal gains from full disclosure of research findings decline. Two conditions suggest that the present level of private R&D for medical devices is generally adequate. First, if industrial R&D responds to the demands of the market, as has been suggested by several observers (273,276), then the high level of demand for medical devices resulting from health insurance and other third-party payment for health care would argue that medical devices R&D has been adequately, perhaps more than adequately, stimulated. Second, the $5.4 billion Federal investment in health R&D (404) provides a rich and continuing source of new scientific knowledge that creates opportunities for devel- opment of new medical devices. Against this positive picture for R&D on med- ical devices is the potentially deleterious effect of premarket regulation on the cost and uncertainty of investment in R&D for new medical devices. A Louis Harris survey reported that because of FDA regulations, 27 percent of responding firms stated that they would not consider developing a new Class III device and another 11 percent stated that they would be unlikely to consider any device development (197). 1°A new Class III device must be approved by FDA as safe and effective prior to marketing (see ch. 5). Ch. 4—Research and Development Policies Related to Medical Devices ® 93 However, the available evidence seems to sug- gest that, except perhaps for small firms and man- ufacturers of Class III devices, the medical devices regulations as they have been implemented have not added substantially to the cost of develop- ment, because the vast majority of devices intro- duced since the passage of medical device regu- lations in 1976 have not been required to undergo rigorous premarket testing (see ch. 5 for details). However, firms have been subject to some uncer- tainty about how the regulations would be applied. The Federal Government has recently embarked on a new strategy —the SBIR program —that does not increase overall R&D budgets but instead shifts the allocation of health R&D funds from other uses to the program's recipients (small firms). The NIH SBIR budget is likely to come at least partially from funds that would otherwise be used for basic research and would go to non- profit institutions. Therefore, the program prob- ably results in a small net shift of health R&D funds toward the development of medical devices. It is impossible to know whether this shift is in the best interest of society. Given that the SBIR program will consume an increasing proportion of NIH grant and contract funds in the future, continuing scrutiny of the program's grant solic- itation and selection methods is advisable. There are specific areas where increased tar- geted Federal support of R&D on medical devices may be justified. True orphan devices—those meeting the dual criteria of high per-unit cost of development and distribution relative to poten- tial users’ ability to pay and high value in rela- tion to cost—are by definition worthy of support. However, it is difficult to differentiate between devices that lack a sufficient market because those who value them highly cannot afford them and devices that lack a market because their extra benefits to society do not outweigh the costs of bringing them to market. Sound criteria for iden- tifying devices meeting the ideal definition of or- phan have not been developed either in the law or in regulations. The problem of orphan devices may grow as pressures to contain health care costs lead third- party payers to develop increasingly restrictive payment policies. Because the definition of a true orphan device is inextricably linked to the pol- icies of major third-party payers regarding cov- erage and levels of payment, criteria for identi- fying orphan devices will have to take these pay- ment policies into account. There appear to be sound theoretical reasons for supporting development of devices meeting the ideal definitions of orphan: high value in rela- tion to cost and high per-unit cost of development and distribution relative to potential users’ ability to pay. Whether in practice there are many de- vices that meet this definition, however, has not been investigated. One way to assist the development of orphan devices, apart from providing direct Federal grants and contracts for R&D, would be to amend the Orphan Drug Act (Public Law 97-414) to make orphan devices eligible for the tax credits and grants offered under that act. The act currently provides a 50-percent tax credit for all clinical testing expenses associated with an orphan drug and authorizes the Secretary of Health and Human Services to make grants for clinical testing. It is important to recognize, however, that the cur- rently inadequate definition of orphan products in the law, which depends on the “rare disease” criterion to identify orphan drugs, may encourage devices that are not worth their costs to society to be designated as orphans. Thus, it would prob- ably be premature to change the law until criteria and methods of analysis are developed that will allow for adequate differentiation between devices that lack a market because they are truly orphaned and those that are simply not worth their costs to society. Option 1: Mandate that DHHS develop criteria and methods for identifying true orphan devices. This option would be particularly useful now, when Medicare is implementing restrictive new payment policies in hospitals and changes in phy- sician payment are being contemplated. Without adequate methods for assessing the extent to which a given device meets criteria for orphan- hood, decisions about R&D subsidies (either 94 e Federal Policies and the Medical Devices Industry through direct grants or tax subsidies) for orphan device development are unlikely to be appro- priate. Because the criteria for orphanhood go well beyond issues of safety, effectiveness, and disease incidence to payment issues, the development of such criteria and methods would probably require participation of a number of constituent agencies of DHHS, including FDA, NIH, and the Health Care Financing Administration. oS. Regulation of Medical Devices by the Food and Drug Administration INTRODUCTION The Medical Device Amendments of 1976 (Pub- lic Law 94-295) consolidated and expanded ex- isting Federal authority over medical devices into a system of regulating the safety and effectiveness of medical devices in proportion to the degree of risk that they pose. In the past 2 years, interest in the law has grown because of problems that have surfaced in implementing some key provi- sions and because of concerns regarding the costs of some provisions relative to the incremental gains in safety and effectiveness. The Subcommittee on Oversight and Investiga- tions of the House Committee on Energy and Commerce held hearings on the Food and Drug Administration's (FDA) implementation of the statute in July 1982 (336) and issued an oversight report in 1983 (338). The General Accounting Of- fice also reviewed implementation of the Medi- cal Device Amendments and issued its report in September 1983 (331). Most recently, in February 1984, the Subcommittee on Health and the Envi- ronment of the House Committee on Energy and Commerce held oversight hearings on the law and its implementation (337). These hearings and in- vestigations have focused on FDA's priorities and pace in implementing the amendments and on those provisions of the law which, in view of the experiences gained since the law’s enactment, have not worked as intended. The 1976 law, its history, its implementation by FDA, and key unresolved issues are addressed in this chapter. The chapter concludes with a pres- entation of a range of options addressed to the major objectives of the law. LEGISLATIVE HISTORY OF DEVICE REGULATION Medical device regulation was first authorized in the Federal Food, Drug, and Cosmetic Act of 1938. (This act is best known for requiring pre- market notification for the safety of new drugs, a requirement that was extended to include pre- market approval of the efficacy as well as the safety of new drugs in the Drug Amendments of 1962.) The 1938 act defined medical devices as (21 U.S.C. § 321 (h)): . . instruments, apparatus, and contrivances, in- cluding their components, parts and accessories, intended (1) for use in the diagnosis, care, miti- gation, treatment, or prevention of disease in man or other animals; or (2) to affect the structure or any function of the body of man or other animals. The 1938 act authorized FDA to inspect any site in which devices were manufactured, processed, packed, or held (21 U.S.C. § 374). It also author- ized FDA to seize adulterated or misbranded med- ical devices; request an injunction against their production, distribution, or use; or seek criminal prosecution of the responsible manufacturer or distributor. But the agency could not take action until after a device had been marketed. In the early regulatory actions taken against adulterated or misbranded devices, FDA was able to use expert testimony to prove its allegations. Over time, however, FDA increasingly had to test devices suspected of violating the law in order to remove these devices from the market (340). As medical devices became more complex after World War II, attention turned to the regulation of legitimate devices as well. But FDA could still act only after devices were distributed and also 97 98 e Federal Policies and the Medical Devices Industry had the burden of proving that a particular item was misbranded or unsafe, because devices were not subject to premarket approval (12). In the late 1960s, however, the courts ruled that certain products (such as nylon sutures and antibiotic- sensitive discs) that fell in the grey area between drugs and devices could legally be considered drugs and subjected to premarket approval re- quirements for new drugs (12,302); subsequently, FDA regulated as “new drugs” such products as some intrauterine devices (IUDs), some contact lenses, and some in vitro diagnostic products. Furthermore, during the late 1960s, Congress addressed public health problems associated with radiation emissions from electronic products. Under the Radiation Control for Health and Safety Act of 1968 (Public Law 90-602), Congress estab- lished a radiation control program to authorize the establishment of standards for electronic products, including medical and dental radiology equipment. From the early 1960s to 1975, six Presidential messages were given and 28 bills were introduced to enact medical device legislation. A 1969 Department of Health, Education, and Welfare review of the scientific literature for in- juries associated with medical devices that was conducted by the Cooper Committee (named after its chairman, Theodore Cooper, then Director of the National Heart, Lung, and Blood Institute of the National Institutes of Health) estimated that over a 10-year period, 10,000 injuries were asso- ciated with medical devices, of which 731 resulted in death (339). The vast majority of these problems were asso- ciated with three device types: artificial heart valves, 512 deaths and 300 injuries; cardiac pace- makers, 89 deaths and 186 injuries; and intrauterine contraceptive devices, 10 deaths and 8,000 injuries (339). As observers noted, however, there had been no sensational event or public tragedy to spur more stringent regulation of medical devices such as the events leading to the 1962 Drug Amend- ments (165,328). Additional examples of hazards associated with medical devices were documented in congressional hearings in 1973. These included prosthetic and orthopedic implants of improper materials, car- diac defibrillators with faulty electrical circuitry, incubators in which temperatures reached as high as 145° F, plastic tracheotomy tubes with obstruc- tions, and faulty valves on emergency oxygen respirators (339). The developments just described eventually culminated in the enactment of the Medical De- vice Amendments of 1976 (Public Law 94-295). THE MEDICAL DEVICE AMENDMENTS OF 1976 The situation prior to enactment of the Medical Device Amendments in 1976 was that FDA could impose premarket approval requirements on only a limited number of devices that could legally be considered new drugs (see above). FDA did have the power to inspect the premises where devices were manufactured and distributed, but had no power to require that owners of these premises notify FDA that they were in the device business. And FDA could attempt to remove mislabeled or unsafe devices only on a case-by-case basis after the devices had been marketed. As a result of the 1976 Medical Device Amend- ments, FDA currently has the authority: ® to require that businesses involved with med- ical devices register their establishments and list their devices annually, ® to impose regulatory requirements (standards or premarket approval) in proportion to the degree of risk of a device, and ® to impose other general controls on all de- vices to assure safety and effectiveness. FDA continues to have the authority granted by the 1938 act to inspect any establishment in which devices are manufactured, processed, or packed, whether or not these establishments are exempt from registration. Ch. 5—Regulation of Medical Devices by the Food and Drug Administration ¢ 99 The definition of medical device was changed in the 1976 amendments to (Public Law 94-295): . . an instrument, apparatus, implement, ma- chine, contrivance, implant, in vitro reagent, or other similar or related article, including any com- ponent, part or accessory, which is— (1) recognized in the official National Formulary, or the United States Pharmacopeia, or any supplement to them, (2) intended for use in the diagnosis of disease or other conditions, or in the cure, mitigation, treatment, or prevention of disease, in man or other animals, or (3) intended to affect the structure or any func- tion of the body of man or other animals, and which does not achieve any of its principal intended purposes through chemical action within or on the body of man or other animals and which is not dependent upon being metab- olized for the achievement of any of its prin- cipal intended purposes. This last clause in the definition (not achieving its principal purposes through “chemical action within or on the body” and “not dependent upon being metabolized”) distinguishes devices from drugs. Devices are to be categorized by type, on the basis of recommendations from FDA classifica- tion panels, into three regulatory classes reflect- ing their potential risk: ® Class I—general controls, ® Class II—performance standards, and ® (Class III—premarket approval. Class I, general controls, encompasses devices for which general controls authorized by the act are sufficient to provide reasonable assurances of safety and effectiveness. Tongue depressors are an example. Manufacturers of Class I and all other devices must register their establishments and list their devices with FDA, notify FDA at least 90 days before they intend to market the device, and conform to good manufacturing practices. Good manufacturing practices apply to the manufactur- ing, packing, storage, and installation of devices. Class II, performance standards, contains de- vices for which general controls are considered insufficient to ensure safety and effectiveness and information exists to establish performance stand- ards. X-ray devices are an example. Class III, premarket approval, applies to de- vices for which general controls are insufficient to ensure safety and efficacy, information does not exist to establish a performance standard, and the device supports life, prevents health impair- ment, or presents a potentially unreasonable risk of illness or injury. Cardiac pacemakers are an example. Preamendments devices were to be so classified and placed in Class I, II, or III. Postamendments devices found to be “substantially equivalent” to products on the market before 1976 were to be put into the same class as their preamendments counterparts and could be marketed immediately, although those in Class III could eventually be re- quired to demonstrate safety and effectiveness. Other postamendments devices were to be auto- matically classified into Class III, although the manufacturer could petition FDA for reclassifica- tion into Class I or II; thus, these devices could not be marketed until they had completed FDA premarket approval for safety and effectiveness. In implementing the 1976 amendments, pre- amendments Class III devices and their postamend- ments substantially equivalent counterparts were to be treated differently from truly new post- amendments Class III devices. The 1976 amend- ments stipulate that manufacturers of preamend- ments Class III devices cannot be required to present safety and effectiveness evidence until 30 months after the effective date of a final classifica- tion regulation or until 90 days after publication of a final regulation requiring submission of evi- dence on safety and effectiveness, whichever period is longer (21 U.S.C. § 351(f)(2)(B)). In the interim, preamendments Class III devices and their postamendments substantial equivalents can con- | tinue to be marketed, subject only to the same | general controls as applied to Class I devices. Manufacturers of any of the following devices are required by section 510(k) of the law to notify FDA at least 90 days prior to marketing them: ® a device that is to be marketed for the first time, ® a device or product line that may be similar to one already marketed by another manu- facturer, or ® aversion of an existing device in a form sig- 100 * Federal Policies and the Medical Devices Industry nificantly changed or sufficiently modified to affect its safety and effectiveness. The manufacturer's 510k premarket notification must contain enough information so that FDA can determine whether or not the device is “substan- tially equivalent” to a device already being mar- keted. To be found substantially equivalent, a postamendments device need not be identical to a preamendments device, but must not differ markedly in materials, design, or energy source. The legislative history reflects a congressional intent that the term “substantially equivalent” be construed narrowly where necessary to assure safety and effectiveness, but less narrowly in in- stances where differences between a postamend- ments device and a preamendments device did not relate to safety and effectiveness (340). If FDA determines that a postamendments device is sub- stantially equivalent to one already in use, the manufacturer may market the device. If FDA finds that a device is not substantially equivalent to one already in use before the 1976 amendments, the device must go through a pre- market approval process. In this case, it is auto- matically classified into Class III, although the manufacturer may petition FDA to reclassify it into Class I or Class II. (Class I devices can be marketed, subject only to the general controls summarized earlier. Since FDA has published no performance standards for Class II devices (see section on “Performance Standards” below), these devices have been subject only to general con- | trols.) For a Class III device that is not substan- | tially equivalent to a pre-1976 device, informa- tion must be provided to FDA to document its safety and effectiveness before the device can be approved by FDA for marketing. In order to develop the safety and efficacy in- formation necessary for market approval of a Class III device, the sponsor of such a device may apply to FDA for an “investigational device ex- emption” (IDE). An IDE, the parallel to the in- vestigational new drug (IND) process in drug reg- ulation, permits limited use of an unapproved device in controlled settings. Upon completion of clinical investigations under the IDE, the spon- sor may submit to FDA a premarketing approval application (PMAA) presenting the results of the clinical investigations, an explanation of what the device consists of and how it works, manufactur- ing data that show compliance with good manu- facturing practices, and other information that FDA may require. If FDA approves this PMAA, the device may be marketed. (The amendments provide an alter- native to the IDE/PMAA route to marketing ap- proval for Class III devices, called a “product de- velopment protocol,” but this has never been used. The major difference between the product development protocol and the IDE/PMAA proc- ess is that in the former, FDA would participate in deciding how the device is to be tested. Once the product development protocol is completed, the testing results would be submitted to FDA for approval of the device for marketing (388).) Finally, the situation for certain “transitional devices” (i.e., devices that were regulated as “new drugs” before enactment of the 1976 amendments) is comparable to that for postamendments devices that are not substantially equivalent to preamend- ments devices. Transitional devices are automat- ically classified into Class III, which requires premarket approval, but may be reclassified, subsequent to petitioning FDA, into Class I or Class II. The current process of getting a medical device to market is summarized in figure 1. The Medical Device Amendments contain other provisions worth noting that are applicable to all medical devices. First, sale, distribution, or use of a device may be restricted by FDA if there can- not otherwise be reasonable assurances of its safety and effectiveness. A device may be banned if it presents substantial deception or an unreason- able and substantial risk of illness or injury. Second, manufacturers, importers, and distrib- utors of devices may be required to establish and maintain additional records, make reports, and provide information to FDA to assure that their devices are safe and effective. Third, devices are subject to the color additive provisions of the Federal Food, Drug, and Cos- metic Act, but only if the color additive comes in direct contact with the body for a significant period of time. Ch. 5—Regulation of Medical Devices by the Food and Drug Administration ¢ 101 Figure 1.—How To Get to Market With a Medical Device Medical device 201(h) Or exempt 21 CFR 807.65 Rd 21 CFR 807.85 MARKET I e.g., veterinary devices general purpose articles devices used in research and teaching custom devices Premarket ce Transitional notification Class | and Il Reclassification | device -<& petition 510(k) 520(1) 1 (no) 513(f)(1) o —/ Reclassification |g petition 513(f)(2) [| 21 CFR 860.12C 1 1 Investigational Product device exemption development 520(g) protocol 21 CFR 812 515(f) Approved [ Co | pprov Premarket mpleted Premarket notification approval application 510(k) 515(c) Approved voy MARKET af SOURCE: U.S. Department of Health and Human Services, Food and Drug Administration, Bureau of Medical Devices, Regulatory Requirements for Marketing a Device (Washington, DC: U.S. Government Printing Office, 1982). 102 e Federal Policies and the Medical Devices Industry Fourth, because of concern over the impact of the 1976 amendments on small manufacturers, a provision of the law stated that an office should be established to provide technical assistance to small firms. FDA has therefore organized an Of- fice of Small Manufacturers Assistance to help small firms with the regulatory requirements. Finally, any medical device that can be mar- keted legally in the United States can be exported legally without further approval by the FDA. Medical devices that have not been approved for use in the United States may also be exported under certain conditions. Prior FDA approval is needed for export of devices that: 1) are in viola- tion of performance standards, 2) are subject to premarket approval, 3) are subject to limited use under an IDE, or 4) are banned in the United States. These four types of devices can be exported only if they have the approval of the country to which the device is to be exported, and if FDA has determined that exportation of the device is not contrary to public health and safety (21 U.S.C. § 381(d)(2)). Any other type of device that can- not be marketed in the United States may be ex- ported without FDA approval if the device: 1) meets the specifications of the foreign purchaser, 2) does not conflict with the laws of the country of the foreign purchaser, 3) is labeled for export, and 4) is not sold or offered for sale domestically (21 U.S.C. § 381(d)(1)). Although prior FDA ap- proval is not required, FDA can at any time re- quire the exporter of such a device to show that the aforementioned requirements are being met. IMPLEMENTATION OF THE MEDICAL DEVICE LAW Registration of Firms and Listing of Devices Federal regulations require the following busi- nesses involved with medical devices to register their establishments with FDA and list their de- vices annually (21 CFR pt. 807.20): ® manufacturers and other specified processors of devices, ® manufacturers of device components or ac- cessories that are ready to be used for and labeled for a health-related purpose, ® initiators or developers of device specifications, ® repackagers and relabelers, and ® initial distributors of imported devices. Manufacturers of device components and raw materials who would not otherwise be required to register, dispensers of devices, licensed medi- cal practitioners, manufacturers of general-pur- pose articles, manufacturers of devices solely for veterinary use, and manufacturers of devices solely for research and training are exempt from registration (21 CFR pt. 807.65). The number of device establishments registered with FDA in 1980 was 6,073. (This number dif- fers from the number of establishments cited in ch. 2, mainly because the FDA list includes non- manufacturing entities such as distributors.) By 1982, the number had increased to 7,636 regis- tered establishments, 6,585 domestic and 1,051 foreign, listing approximately 41,500 products. More than 95 percent of the establishments had fewer than 500 employees, and more than half had fewer than 50 employees (143). Registration lists change significantly from year to year. In 1983, for example, 1,100 firms canceled their medical device status, while 1,800 firms registered for the first time with FDA (206). Two studies by FDA's Office of Planning and Evaluation measured “baseline” conditions in or- der to track changes that may occur in the future. Some of the studies’ principal findings on device establishments in 1980 were as follows (392): e Eighty-two percent of registered domestic establishments manufactured devices, 20 per- cent imported devices, and 22 percent re- packaged devices (device establishments may have more than one function). ® Sixty-nine percent of domestic establish- ments were the sole site operated by the owner/operator, while 28 percent were sub- sidiaries, branches, or divisions. Ch. 5—Regulation of Medical Devices by the Food and Drug Administration e 103 ® Ninety-three percent of domestic owner/ operators (3,948 out of 4,245 in 1980) oper- ated only one medical device establishment. ® Forty-two percent of the domestic establish- ments had 20 or fewer employees, while 29 percent had 100 or more employees. ® Larger establishments were more likely than small establishments to: 1) produce more types of devices, 2) make an “exclusive” de- vice (a device made by only one or two establishments), 3) make a Class III device, or 4) make a “critical” device (defined below in the section on “Good Manufacturing Practices”). ® Sixty-four percent of listed manufacturers made devices in only one medical specialty area (as defined by FDA's list of classifica- tion panels). ® Medical device establishments other than those making diagnostic devices averaged 4.4 products each, while diagnostic device estab- lishments averaged 6.4 products each. ® There was little overlap between manufac- turers of medical devices and diagnostic de- vices. Establishments making dental, oph- thalmic, and radiological devices were also highly specialized. Therefore, there appears to be a segmentation of the industry between medical and diagnostic devices, and a further segmentation of the medical devices portion of the industry between establishments that are highly specialized and those that make devices in several areas. The other study (391) looked at “availability” of devices, or the number of products for each device type. A device type may include all prod- ucts of a particular type (e.g., cardiac pacemakers) or may include groupings of separate types of devices that are similar. The more products of a type, the greater the availability of products of that type. The analysis in this study was based on device classifications that were established enough to use at the time of the analysis, or devices from about half of the FDA classification panels established (see “Classification” section below). Its principal findings on availability were as follows (391): ® On average, there were nine products per type, i.e., each device type was made by an average of nine establishments. ® Product availability was related to class of device. Class I device types averaged 13.1 products per type; Class II, 7.9 products; and Class III, 4.5 products. ® Devices with only one or two manufacturers comprised 28 percent of all device types. Forty-one percent of Class III, 28 percent of Class II, and 24 percent of Class I device types had only one or two manufacturers. ® Foreign establishments made 17 percent of the products examined. Eleven percent of all exclusive types had only foreign manufac- turers; 4 percent were made solely by foreign manufacturers. ® Foreign products accounted for 21 percent of Class III devices, 19 percent of Class II, and 15 percent of Class I devices. ® More than one-third of all obstetrics-gyne- cology products and nearly two-thirds of Class I neurological products were of foreign origin. Premarket Notification In addition to listing their devices annually, de- vice establishments must notify FDA through the 510k notification process (see above) when they intend to market new devices. Postamendments devices that are not found by | FDA to be “substantially equivalent” to preamend- || ments devices or to postamendments devices that have been reclassified into Class I or II are pre- sumed to be Class III, and hence to need pre- | market approval unless the device's sponsor suc- | cessfully petitions FDA to reclassify the device | into Class I or II. However, the overwhelming ma- || jority of postamendments devices are from man- || ufacturers who are marketing existing device types || for the first time or who have devices that are mi- nor modifications of existing devices. Thus, the 510k premarket notification process, together with | the FDA finding that devices are substantially | equivalent to preamendments devices, has become | the predominant route by which postamendments devices have reached the market. An indication of the extent to which postamend- ments devices have been regulated through the 510k notification process is reflected in the fact that, of more than 17,000 notifications received for fiscal year 1977 through fiscal year 1981, only 104 e Federal Policies and the Medical Devices Industry approximately 300 were found to be not sub- stantially equivalent and therefore automatically placed in Class III. For 65 of these, petitions for reclassification were received; 28 were approved, 5 denied, 28 withdrawn or converted to other types of submissions, and 4 were still active at the end of fiscal year 1981. Of the 28 approvals, 3 were reclassified from Class III to I, and 25 from Class III to II (143). The number of 510k submis- sions and the number of submissions found not substantially equivalent since 1976 are summa- rized by year in table 32. The purpose of the 510k notification process was to keep FDA apprised of what was going on in the industry. The concept of “substantial equiv- alence” was included in the law to address the question of how to treat pre- and postamendments devices fairly. Two issues were involved: 1) a dou- ble standard would exist if a postamendments de- vice had to go through the premarketing approval process before it could be marketed, while an identical preamendments device would continue to be marketed; and 2) a type of monopoly would in effect be given to a preamendments device if identical pre- and postamendments devices were treated differently. The 510k process, together with a determina- tion of substantial equivalence, has been used ex- tensively for postamendments devices to avoid Table 32.—Number of “510k” Submissions and Number Found Not Substantially Equivalent,. 1976-83 Number Number found not of “510k” substantially Year submissions equivalent 1976 (7 months)... ... 1,362 8 1977 2,427 47 1978 2,180 43 1979 LL. 2,714 44 1980 ............... 3,316 73 1981 o.oo 3,652 63 1982 3,7802 55 1983 oii NAP 32d Total ............. 19,431¢ 365¢ 8Estimate. DNA indicates information not available. CExcluding 1983. das of July 1983. SOURCE: U.S. Department of Health and Human Services, Food and Drug Ad- ministration, unpublished data, Silver Spring, MD, 1983. ee — Class III designation and its automatic require- ment for premarket approval, or to avoid the in- volved rulemaking process necessary to reclassify such devices from Class III to Class I or II. Use of the substantial equivalence clause to per- mit the marketing of devices without premarket approval has been encouraged by FDA's regula- tions and practices. First, FDA's initial proposed regulations that would have required submission of a 510k notice if modifications could affect safety and effectiveness were changed. In the pro- posed regulations, if FDA determined that modi- fications could affect safety and effectiveness, there would be no finding of substantial equiva- lence, and an evaluation of the difference would have been made in a PMAA or in a reclassifica- tion petition from automatic Class III designation (53). In the final regulation, however, FDA changed the wording to “changes that could significantly \ affect the safety or effectiveness of the device” (emphasis added) (21 CFR pt. 807.81(a)(3)(i)). Second, FDA allows manufacturers to trace back through a chain of substantially equivalent postamendments devices to a device on the mar- ket before the amendments were enacted. For ex- \ ample, a 1982 device may be approved as substan- tially equivalent to a 1981 device, which was approved as equivalent to a 1979 device, and so on eventually back to a preamendments device. This practice has been labeled “piggybacking” or, alternatively, “equivalence creep” (53,331). Third, the amount of data required to show substantial equivalence varies widely, depending on the device. All devices that have been deter- mined not to be substantially equivalent and which thus must go through premarket approval are reviewed centrally, but there is no such cen- tral review for devices that have been found to be substantially equivalent (47). Another issue relating to the 510k notification process is whether or not notification require- ments should be applied to Class I devices. In Sep- tember 1982, the Scientific Apparatus Makers Association petitioned FDA to drop 510k notifica- tion requirements for Class I device types and to simplify reporting requirements for Class II and III (82). The petition claimed that Class I devices would still be subject to the registration require- Ch. 5—Regulation of Medical Devices by the Food and Drug Administration ¢ 105 ments and to surveillance under the good manu- facturing practices regulations. Furthermore, notification of intent to market Class II devices for which no standards exist could be simplified, and additional information could be required only for Class III devices and for Class II devices that have performance standards. The petition claimed that these changes would still pro- vide reasonable assurances against new devices being marketed without a change in classification or without premarket approval. FDA subsequently denied the petition, telling the Scientific Apparatus Makers Association that the legislative intent was to make decisions on the basis of generic types of devices, not whether or not devices were in Class I (80). In addition, FDA was already exempting some device types from 510k notification requirements. For example, in its final rule on classifying General Hospital and Personal Use devices, FDA exempted 30 generic types of Class I devices from notification require- ments. They included medical absorbent fibers and specimen containers, if the devices are not labeled or otherwise represented as sterile (306). Classification of Devices By the beginning of 1984, FDA had completed classification of preamendments device types in only 11 of its 19 medical specialty sections and had issued proposed classifications for the other 8 sections (see table 33). Final and proposed clas- sifications as of February had placed 460 device types in Class I, 1,086 in Class II, 138 in Class III, and, depending on the particular product or use of the product of a specified device type, 27 in Class I or II, 13 in Class II or III, and one in Class I, II, or III (see table 34). A “device type” may include all products of a particular type (see discussion of availability in the section above, “Registration of Firms and Listing of Devices”) or may include groupings of separate types of devices that are similar. Thus, for example, the device type “obstetrics-gyne- cology specialized manual instruments” was formed by merging 18 separate instruments such as um- bilical clamps, gynecological surgical forceps, and uterine sounds (391). 25-406 O - 84 - 8 Documentation of safety and effectiveness for preamendments Class III devices was not imme- diately required but eventually has to be sub- mitted for marketing to continue. As previously explained, the 1976 amendments provided a grace period of 30 months before such requirements could be imposed, but the grace period does not begin until final classification is made. Therefore, for example, the earliest date that FDA could call for evidence of safety and effectiveness of Class III devices in the eight medical specialty sections for which final classifications had not been made at the beginning of 1984, even if they were finally classified early in the year, would be in 1986. For the 11 medical specialties with final classifications, the grace period had ended for 6 by 1984 (see table 34). Tables 33 and 34 show the number of Class III device types for which the 30-month grace period applies. An indication of the number of device products that are involved can be gleaned from the number of postamendments Class III devices found to be substantially equivalent to preamend- ments Class III devices. The number of such prod- ucts is summarized in table 35 by medical specialty and year of notification. From the table, it can be seen that, in addition to Class III products on the market prior to the 1976 amendments, there were over 1,000 postamendments Class III prod- ucts in use by 1983 through a finding of substan- tial equivalence. Nearly two-thirds of these prod- , ucts were cardiovascular devices. On May 5, 1982, the Health Research Group petitioned FDA to issue regulations requiring de- vice manufacturers to submit PMAAs for pre- amendments Class III neurological devices (252). These devices had been classified in final regula- tions effective October 4, 1979, and the Health Research Group had petitioned FDA shortly after the 30-month grace period had ended. FDA's re- sponse was that the 30-month time period estab- lished only the earliest date FDA could act (85). The Health Research Group subsequently wrote to Rep. John Dingell (D-Mich.), Chair of the House Committee on Energy and Commerce and also Chair of its Subcommittee on Oversight and Investigations, asking that oversight hearings be held and that there be consideration of an amend- 106 e Federal Policies and the Medical Devices Industry Table 33.—Classification of Preamendments Device Types by Medical Specialty Category, February 1984 Class lor lor 1, 1, Medical specialty category Proposed | 1 1] 1 1] or lll Total Neurology... ovvvie ieee 11/28/78 9/4/79 24 66 1" 0 0 0 101 Cardiovascular ........................ 4/9/79 2/5/80 3 108 24 1 2 0 138 Obstetrics-gynecology ................. 4/3/79 2/26/80 5 48 16 0 0 0 69 Hematology) ...........cooiiiion.. 9/11/79 9/12/80 | (combined) .............. 42 60 6 0 1 0 109 Pathology J ....... cco... 9/11/79 9/12/80 General hospital and personal use ....... 8/24/79 10/21/80 51 39 2 2 0 0 94 Anesthesiology ............... oa. 11/2/79 7/16/82 21 105 7 0 1 0 134 Immunology | «ovine 4/22/80 11/9/82 | (combined) ............. 93 64 5 0 0 0 162 Microbiology J ....... oii 4/22/80 11/9/82 Physical medicine ..................... 8/28/79 11/23/83 32 42 2 0 5 0 81 Gastroenterology-urology ............... 1/23/81 11/23/83 9 32 9 4 2 0 56 Subtotal ....... 280 564 82 7 1 0 944 Dental ........coiiiiiiiii iii 12/30/80 49 122 13 1 0 0 185 General and plastic surgery ............. 1/19/82 23 25 5 0 1 0 54 Ear, nose, and throat. .................. 1/22/82 10 47 10 0 0 0 67 Ophthalmology .............ccovenin.. 1/26/82 45 51 4 19 0 0 119 Radiology .....ovviiii ii 1/29/82 7 64 0 0 1 1 73 Clinical chemistry } ................... 2/12/82 (combined) ........ 31 175 0 0 0 0 206 Clinical toxicology) ................... 2/12/82 Orthopedics ............coiiii. 712/82 15 38 24 0 0 0 77 Subtotal .............. a. 180 522 56 20 2 1 781 Total «vee 460 1,086 138 27 13 1 1,725 SOURCE: Federal Register publications of specified dates. Table 34.—Classification Status of Preamendments Device Types, February 1984 Class lor Ilor III, Status | 1 11] Il I orlll Total Final ........ 280 564 82 7 11 0 944 Proposed . . . .. 180 522 56 20 2 1 781 Total ....... 460 1,086 138 27 13 1 1,725 SOURCE: See table 33. ment to the device amendments that would clearly establish a definite time for submission of data for preamendments and substantially equivalent Class III devices (83). The Health Research Group petitioned FDA again in March 1983, this time for preamendments Class III obstetrics-gynecol- ogy devices and their substantial equivalents, pointing out that the 30-month grace period had ended on August 31, 1982 (253). In September 1983, FDA issued its first “Notice of Intent” to initiate proceedings requiring ap- proval for continued marketing of preamend- ments Class III devices and their postamendments substantial equivalents in the five medical spe- cialty categories for which the 30-month grace period had expired. FDA identified the following devices in these five medical specialty categories as being the first device types for which safety and effectiveness evidence would be required (321). ¢ Hematology and Pathology (combined) 1. Automated differential cell counter 2. Automated heparin analyzer 3. Automated blood cell separator e Cardiovascular 1. Implantable pacemaker pulse 2. Pacemaker programmer 3. Replacement heart valve ® General hospital and personal use 1. Infant radiant warmer ¢ Neurology 1. Implanted cerebellar stimulator 2. Implanted diaphragmatic/phrenic nerve stimulator 3. Implanted intracerebral /subcortical stim- ulator for pain relief Ch. 5—Regulation of Medical Devices by the Food and Drug Administration e 107 Table 35.—Number of Postamendments Class lll Devices Found Substantially Equivalent to Preamendments Devices by Medical Specialty Category, 1976-83 1976 1983 Medical specialty category (7 mos) 1977 1978 1979 1980 1981 1982 (as of 7/83) Total Anesthesiology?. ..........ooiiiiiii nn 1 3 5 3 9 3 1 2 27 Cardiovascular? ............cooiiiiiian. 33 al 89 121 114 143 94 51 716 Clinical chemistry ......................... 0 0 0 0 1 2 0 0 3 Clinical toxicology ........c.oviiiin.n. 0 0 0 0 0 1 0 0 1 Dental . ovis 2 6 5 5 4 6 11 3 42 Ear, nose, and throat ....................... 0 3 3 6 5 0 3 0 20 Gastroenterology-urology? .................. 0 4 2 3 8 5 8 10 40 General and plastic surgery ................. 6 5 2 6 5 14 2 5 45 General hospital and personal use? .......... 0 1 0 2 2 2 2 1 10 Hematology? ..........coiiiiiiiinnnnnnnns 0 9 2 8 4 0 3 1 27 Immunology? .... oe 1 4 1 1 3 3 2 1 16 Microbiology®. .......iii a 0 5 4 8 12 10 3 1 43 Neurology? . .. coe 5 6 2 3 8 5 2 0 31 Pathology? ..... c.count 0 0 0 0 0 0 2 0 2 Obstetrics—-gynecology? .................... 2 2 3 1 3 2 0 2 15 Ophthalmology ..........ccooiiiiinnnennn.. 2 3 7 5 3 3 9 6 38 OrthopediCs «ov viii 0 1 0 1 2 2 0 2 8 Physical medicine? ...............cooinnn.. 0 1 1 1 0 0 0 0 3 Radiology « «vv vee 0 0 0 1 0 1 3 0 5 Total «vee 52 124 126 175 183 202 145 85 1,092 aClassification completed (as of the end of 1983) (see table 33). SOURCE: U.S. Department of Health and Human Services, Food and Drug Administration, unpublished data, Silver Spring, MD, 1983. e Obstetrics-gynecology 1. Transabdominal amnioscope (fetoscope) and accessories 2. Contraceptive uterine device (IUD) and in- troducer 3. Contraceptive tubal occlusion device (TOD) and introducer The Federal Register notice also announced that FDA was proposing a rule to require the filing of a PMAA for one of these devices, the implanted cerebellar stimulator. Four months after the an- nouncement, no PMAAs had been submitted, probably because of difficulty in providing data that supported the stimulator’s safety and effec- tiveness (86). If IDEs are obtained, however, the implanted cerebellar stimulator may continue to be used for the limited purpose of obtaining safety and effectiveness data from clinical trials (321). Reclassification of Devices As explained earlier, the sponsors of postamend- ments devices that are not substantially equivalent to preamendments devices and are automatically put in Class III may petition FDA for reclassifica- tion into Class I or II. The major reclassification issue has not been with these devices, however, but with one of the transitional devices—contact lenses. Under the 1976 Medical Device Amendments, transitional devices (products that had previously been regulated as “new drugs”) were automatically classified in Class III and made subject to pre- market approval requirements, although the man- ufacturers could petition FDA for reclassification. All contact lenses made of polymers other than polymethyl-methacrylate (hard lenses) had been previously declared to be “new drugs” and placed in Class III when the 1976 amendments were enacted. Subsequently, some manufacturers did the testing required to meet the premarket ap- proval requirements. In March 1981, the Contact Lens Manufacturers Association (CLMA), representing predominantly small contact lens manufacturers, petitioned FDA to reclassify from Class III to II contact lenses con- sisting principally of rigid plastic materials. CLMA's contention was that these lenses were safe and ef- fective enough to be placed in Class II, thus mak- ing further testing unnecessary. FDA subsequently concluded that CLMA's peti- tion did not meet all of the requirements of the regulations (21 CFR pt. 860.123). The agency also 108 * Federal Policies and the Medical Devices Industry 1932 Early 1950s Mid 1970s Photo credits: Alan R. Kahn This picture shows three steps in the evolution of the cardiac pacemaker, from a device carried on the patient’s back, to an external device with internal leads, to a fully implantable pacemaker. Implantable cardiac pacemakers are regulated as Class lll devices. determined that the objective of CLMA's petition In December 1983, FDA withdrew the proposed was meritorious, however, and in November rule on rigid gas-permeable lenses on the basis of 1982, proposed to reclassify both daily-wear soft the fact that its review found insufficient publicly contact lenses and daily-wear rigid gas-permeable available, valid scientific evidence to show that contact lenses from Class III to Class I (rather than the device was safe and effective (323). The in- to Class II) (313). formation had to be based on “valid scientific Ch. 5—Regulation of Medical Devices by the Food and Drug Administration e 109 evidence” (21 CFR pt. 860.7(c)), and that evidence had to be publicly available because the 1976 amendments prohibit the use of trade secrets, con- fidential commercial information, or detailed in- formation on safety and effectiveness contained in the premarket approval application of manu- facturers who have succeeded in obtaining ap- proval for their devices. Following its decision not to down-classify rigid gas-permeable contact lenses, however, FDA decided to review its contact lens guidelines for IDEs and PMAAs to determine under what con- ditions some parts of the guidelines could be avoided, thereby simplifying the premarket ap- proval process (207). Good Manufacturing Practices Good manufacturing practices regulations, which apply to the manufacturing, packing, stor- age, and installation of devices, are one of the im- portant ways in which Class I devices were to be regulated. They also apply to Class II and III devices. The good manufacturing practices regulations implemented by FDA for device manufacturers distinguish between “critical” and “noncritical” devices (21 CFR pt. 820): “Critical device” means a device that is intended for surgical implant into the body or to support or sustain life and whose failure to perform when properly used in accordance with instructions for use provided in the labeling can be reasonably ex- pected to result in a significant injury to the user. “Noncritical device” means any finished device other than a critical device. Most critical devices are in Class III, but not all Class III devices are critical. The good manufacturing practices regulations require that the manufacturer keep a device mas- ter record containing the device's specifications, production processes, and quality assurance pro- cedures; a historical record of the device indicating control numbers and dates of manufacture and distribution; and complaint files regarding the de- vices performance. For critical devices, the man- ufacturer must have more detailed monitoring of production and distribution and must maintain [ | individual control numbers and device master rec- ords. Additional compliance programs are cited specifically for manufacturers of cardiac pacemakers and sterile devices (389). FDA has exempted man- ufacturers of some noncritical devices in Class I (e.g., specimen containers) from most of the record- keeping requirements of the good manufacturing practices regulations. In a review of reports of good manufacturing practice inspections conducted primarily on Class II and III device manufacturers from January 1979 through December 1981, out of 3,811 good man- ufacturing practices inspections, 62 regulatory ac- tions were taken. FDA concluded that the com- pliance rate for larger firms tended to be somewhat better than for smaller firms, but overall com- pliance by the industry was good, and there was a reasonable level of compliance for smaller firms (143). Performance Standards /* Proposed and final classifications as of early / 1984 had placed nearly 1,100 of the more than 1,700 device types in Class II (see tables 33 and 34, above). Yet no mandatory performance stand- ards have been issued by FDA for any Class II \_device types. Class II has become a de facto catchall regula- | tory category, intermediate between the minimum regulatory requirements imposed by Class I gen- eral controls and the full premarket approval process associated with Class III devices. Opera- tionally, however, because no performance stand- ards have been issued for Class II device types, Class II devices have been regulated as though they were Class I devices. FDA has approached further regulation of Class II device types in several ways. First, in 1982, FDA proposed that the following steps could be con- sidered before promulgation of a mandatory per- formance standard (387): ® request that manufacturers voluntarily solve device problems, ® publicize particular device problems, ® publish educational and technical informa- tion directed at device use, ® participate in developing a voluntary standard, 110 ¢ Federal Policies and the Medical Devices Industry ® make use of other general controls such as those for adulteration and misbranding, and ¢ develop guidelines. Second, in mid-1982, the Administration sub- mitted to Congress a proposal to repeal the pres- ent statutory procedures for developing and estab- lishing performance standards for medical devices by substituting a simpler notice-and-comment rulemaking procedure under the Administrative Procedures Act. The device amendments require a five-step process: 1) initiate by Federal Register notice a proceeding for a performance standard, which provides the opportunity for manufacturers to request a change in classification, denial of re- quests for reclassification, or initiation of reclas- sification by Federal Register notice; 2) invite per- sons by Federal Register notice to submit an ex- isting standard as a proposed performance stand- ard or an offer to develop such a standard; 3) ac- cept or reject such offers or proceed to develop such standards; 4) publish a notice of proposed rulemaking; and 5) promulgate a performance standard (21 CFR pt. 861.20). The proposal the Administration submitted to Congress would have eliminated the second and third steps. Rep. Henry A. Waxman (D-Calif.), Chair of the Subcommittee on Health and the Environment of the House Committee on Energy and Commerce, agreed to sponsor the bill but added a section requiring manufacturers to notify FDA if they learn of device defects that present unreasonable risks of substantial harm (see subse- quent section on “Postmarketing Surveillance” for a related discussion). H.R. 7052, the Medical De- vice Amendments of 1982, was introduced by Rep. Waxman on August 19, 1982, but was not acted on. Similar legislation, including discre- tionary authority to apply performance standards, was reported to be under consideration at the De- partment of Health and Human Services/FDA at the beginning of 1984 (87). Third, in mid-1983, FDA finally identified 11 priority Class II devices, announced its intent to proceed with development of performance stand- ards, and started the five-step process (see above) by providing the opportunity to submit a request for a change in the classification of the first of these 11 devices, the continuous ventilator (320). Do the 1976 Medical Device Amendments in fact require the use of performance standards? Two sections of the amendments seem in conflict on this point. Section 514(a)(1) of the act states that: “The Secretary may by regulation . . . es- tablish a performance standard for a Class II de- vice” (emphasis added). But the act's definition of a Class II device is: “A device which cannot be classified as a Class I device because the [Class I] controls . . . by themselves are insufficient to provide reasonable assurance of the safety and ef- fectiveness of the device, for which there is suffi- cient information to establish a performance stand- ard to provide such assurance, and for which it is therefore necessary to establish for the device a performance standard . . . to provide reason- able assurance of its safety and effectiveness” (em- phasis added) (§ 513(a)(1)(B)). What if there is insufficient information to establish a performance standard? That condition in itself does not require Class III designation. A device is a Class III device if it “cannot be classified as a Class II device because insufficient informa- tion exists for the establishment of a performance standard . . . and (it) is purported or represented to be for a use in supporting or sustaining human life or for a use which is of substantial importance in preventing impairment of human health, or presents a potential unreasonable risk of illness or injury” (emphasis added) (§ 513(a)(1)(C)). FDA, in classifying a device into Class II, has had to conclude that sufficient information to develop performance standards in fact exists (see the def- inition of Class II, above). Yet the fact that no mandatory performance standards have been issued casts doubt on this conclusion. ~ Moreover, FDA has chosen Class II instead of Class III designation even in some cases where a device was of an implantable type. This is il- lustrated by proposed classifications for General and Plastic Surgery devices, where seven im- plantable device types (including artificial chins, ears, and noses) were proposed for Class II in- stead of Class III designation (311). The Health Research Group, commenting on these proposed classifications, stated that implantable devices should be in Class III (253). Ch. 5—Regulation of Medical Devices by the Food and Drug Administration ¢ 111 Investigational Device Exemptions An IDE permits limited use of an unapproved Class III medical device in controlled settings for the purpose of collecting data on safety and ef- fectiveness. This information can subsequently be used in support of a PMAA. The regulations that FDA has implemented on IDEs make a distinction, which is not expressly stated in the law, between “significant risk” and “nonsignificant risk” devices. A “significant risk device” is an investigational device that (21 CFR pt. 812.3(m)): (1) is intended as an implant and presents a po- tential for serious risk to the health, safety, or welfare of a subject; (2) is purported or represented to be for a use in supporting or sustaining human life and presents a potential for serious risk to the health, safety, or welfare of a subject; (3) is for a use of substantial importance in diag- nosing, curing, mitigating, or treating disease, or otherwise preventing impairment of human health and presents a potential for serious risk to the health, safety, or welfare of a subject; or (4) otherwise presents a potential for serious risk to the health, safety, or welfare of a subject. Sponsors of investigations of significant risk devices must obtain approval by an institutional review board, if one exists, and must also apply for an IDE from FDA. Investigations may not begin until FDA approval is granted. The deter- mination of whether a device is a significant risk device is initially made by the sponsor. The in- stitutional review board reviewing the investiga- tional plan also makes this determination and has the authority to approve, require modifications, or disapprove the investigational plan. If the re- view board disagrees with a sponsor's conclusion that a device is a nonsignificant risk device, the sponsor has to notify FDA and apply for an IDE. If no institutional review board exists or if FDA finds the institutional review board's review in- adequate, the sponsor may submit an application for an IDE directly to FDA (21 CFR pt. 812.62). FDA will then decide whether an IDE is needed. The sponsor of a nonsignificant risk device need not apply for an IDE but must obtain approval to test the device from the institutional review board of the institution where testing will occur and must meet certain reporting, recordkeeping, and monitoring requirements. The IDE not only allows device sponsors to test the Class III device before approval is obtained for marketing, but also is a method of keeping FDA apprised of the existence of clinical testing. For nonsignificant risk devices, FDA need not ac- tually be informed of the specifics of testing, and these devices are considered to have approved ap- plications for IDEs as long as the institutional re- view board has approved the testing and certain recordkeeping and other requirements are met (21 CFR pt. 812.2(b)). (At a December 1983 meeting of the Food and Drug Law Institute, an FDA official unofficially raised the idea of a written notification to FDA of the existence of a nonsignificant risk investiga- tion in addition to the normal nonsignificant risk IDE procedures. The principal purpose was to in- form FDA of the existence of clinical testing to ensure that a reasonable amount of safety and ef- fectiveness information was gathered in prepara- tion for premarket approval, and to prevent man- ufacturers from profiting on unapproved devices (81).) In a few instances, FDA guidelines have estab- lished requirements concerning the numbers of pa- tients required in a clinical study and the length of time they need to be followed. For example, in December 1983 FDA advised manufacturers of YAG (yttrium aluminum garnet) lasers, a Class III device which is used in cataract surgery, that a reasonable study population was 500 patients studied for 6 months and that the sponsors should not add to the study without FDA approval (81). The number of significant risk IDEs that have been issued from 1977 to 1982 is summarized in table 36 by medical specialty category. The num- bers in that table reflect the changing status of the IDE regulations. Until 1978, FDA required IDE applications solely for studies of certain Class III devices that had been previously regulated as new drugs (i.e., “transitional devices”). In February 1978, the IDE regulations for intraocular lenses became effective (21 CFR pt. 813), and IDE ap- 112 e Federal Policies and the Medical Devices Industry Table 36.—Investigational Device Exemptions (IDEs) for Significant Risk Devices by Medical Specialty Category, 1977-82 Medical specialty category 1977 Anesthesiology... Cardiovascular ..........coviiiiiiain.. Clinical chemistry ......................... Clinical toxicology... Dental ......ooi Ear, nose, and throat ....................... Gastroenterology-urology ................... General and plastic surgery ................. General hospital and personal use ........... Hematology ........oovviiiniiie. IMMUNOIOGY «vee Microbiology... Neurology . . .. ove Pathology . «.vovveei Obstetrics-gynecology . ................tn Ophthalmology ..........cooviiiieeiennn.. OrthopediCs «viii Physical medicine .................. Radiology « «voi Total «vote NOOO 2100000 ONMAODOOOOOO 19782 1979 1980° 1981 1982 Total 0 0 0 8 11 19 3 2 21 39 32 97 0 2 0 0 1 3 0 0 0 0 0 0 0 1 4 0 2 7 0 0 1 1 4 6 0 1 10 28 21 60 1 2 5 7 12 31 0 0 4 4 4 14 0 0 0 0 0 0 1 0 2 2 0 5 0 0 1 0 0 1 0 3 2 4 9 18 0 0 0 0 0 0 0 0 21 53 34 108° 48 21 24 34 34 162 0 0 4 12 11 27 0 1 0 2 0 3 0 0 6 9 1 16 53 33 105 203 176 577 8)ntraocular lens regulation final in February 1978. IDE regulation final in January 1980. CAlmost exclusively cervical cap studies. SOURCE: U.S. Department of Health and Human Services, Food and Drug Administration, unpublished data, Silver Spring, MD, 1983. plications for intraocular lenses began to be re- ceived. In January 1980, IDE regulations appli- cable to other types of devices were made final (21 CFR pt. 812). The relationship between requests for approval and FDA's finding that IDEs were in fact needed is indicated by the fact that nearly 60 percent of approximately 400 requests for approval of IDEs for significant risk devices that FDA received be- tween July 1981 and July 1982 were approved with or without additional conditions within 30 days. The remainder were disapproved, subject to ad- ditional justification, withdrawn by the sponsor, or returned to the sponsor with the finding that an IDE was not necessary (143). Premarket Approval In 1980, FDA developed guidelines for the sub- mission of PMAAs and also published proposed regulations on premarket approval requirements (308). However, the regulations had not been finalized by early 1984. Under the guidelines cur- rently in use, when a PMAA is approved, the ap- proval letter states that information on adverse reactions and device defects must be reported within 10 days. And according to an FDA pre- scription device regulation (21 CFR pt. 801.109) predating the 1976 amendments, certain devices may be sold or distributed only by or on the or- der of licensed practitioners. FDA has used these restrictions as a condition of approval for certain devices. As indicated earlier, the only types of devices that have had to go through the full premarket approval process so far are: 1) postamendments devices that are not substantially equivalent to preamendments devices, and 2) “transitional de- vices” that have not been reclassified as Class I or II and postamendments devices substantially equivalent to them. Preamendments Class III devices and their postamendments equivalents will eventually have to go through a similar approval process. In September 1983, FDA identified the first 13 preamendments Class III device types for which evidence of safety and effectiveness will soon be required if continued marketing is to be allowed (see section on “Classification of De- vices,” above) (321). The number of postamendments Class III de- vices that have successfully passed through the full premarket approval process and the number of transitional devices that have received pre- market approval from 1977 to 1982 are summar- ized in table 37 by medical specialty category. Ch. 5—Regulation of Medical Devices by the Food and Drug Administration e 113 Table 37.—Approved Premarket Approval Applications (PMAAs) by Medical Specialty Category, 1977-82 Medical specialty category 1977 1978 1979 1980 1981 1982 Total Approved PMAAs: Anesthesiology .................... Cardiovascular ............. iii Clinical chemistry ......................... Clinical toxicology ............... oo... Dental ........ Ear, nose, and throat ....................... Gastroenterology-urology . .................. General and plastic surgery ................. General hospital and personal use ........... Hematology ............... i... Immunology... Microbiology ............ iii Neurology . . «ooo Pathology .......... iii Obstetrics—gynecology ..................... Ophthalmology ...............iiiinon. Orthopedics . «ovine Physical medicine ......................... Radiology .......cooiiii Total «oo ry _ COO WNWOUIOWONO =U xD n nN BloovBoomvaoconmmrmoooooma | o ooo 2 O00 0D000O0O0O0OO0OOODOOOO +O CI O00 0000000000 ODODOOOO 3 OCI OONOODOO0OOUOOO0OO +20 +200 MO 3 et VI OO—-2NOOCOPLPWOARAROOODOON = 5 nN COO -ANOO-=-2NOONPAPOO LAO 2WLW J nN © Approved PMAAs for new devices: Anesthesiology .............. Cardiovascular ..........c.ooiiiiiii. Clinical chemistry ......................... Clinical toxicology ......................... Dental ........... ii Ear, nose, and throat ................ [PU Gastroenterology-urology ................... General and plastic surgery ................. General hospital and personal use ........... Hematology .............................. Immunology... Microbiology .............. iii. Neurology... Pathology ........ccoiii Obstetrics—gynecology ..................... Ophthalmology ...............o iii. OrthopediCs «voi eee ieee Physical medicine ......................... Radiology .....covii Total S| O00 0000000000000 =O CIO O0 O00 O0OO0OO0OO0OO0DO0OODOOOOOOOO Ny NIOOMNOOOOUOO0OO0OO 20 +00WO OCIOO0O +0000 ODO 200 0COOON= al WOOO OOO-NOOMNMNNOOOO—=-NMW 3 WIOO0O +2 00O0ON—L2O0OON=2NOOOCOCO HN locorocoowmoomwwo =o =m (6) w Approved PMAAs for transitional devices: Anesthesiology ........... iii Cardiovascular .............. iii... Clinical chemistry ................ oo... Clinical toxicology... Dental ....... Ear, nose, and throat ....................... Gastroenterology-urology ................... General and plastic surgery ................. General hospital and personal use ........... Hematology ...........ccoiiiiiiin.. Immunology .......cooi Microbiology ............ ci Neurology . ... cv Pathology ........oviiii Obstetrics—-gynecology ..................... OOOO O0OO0OO0OO0OO0OO0OOOOOOoO OOOO O0OO0OO0ODO0OO0OOOOCOOO COO O0OO0OO0ODO0OO0OO0OO0OO0OO0OO =O COO O0OWOOMOOOOOOO COO O0OO0OO0OOMNMNOO +200 —=0O OCO0OO0OO0OO0OO0OO0O—+-00000OO0OO COO OoOWOoOO~NOO—=00OMNMO 114 e Federal Policies and the Medical Devices Industry Table 37.—continued Medical specialty category 1977 1978 1979 1980 1981 1982 Total Ophthalmology ........................... Orthopedics .............................. Physical medicine ......................... Radiology ............. Total o.oo. 0 0 6 12 22 20 60 o 0 0 0 1 1 2 oO 0 0 0 0 0 0 60 0 0 0 0 0 0 0 7 19 2 2 7 SOURCE: VES Department of Health and Human Services, Food and Drug Administration, unpublished data, Silver Spring, Approved transitional devices are heavily skewed toward ophthalmic products, which are almost exclusively contact lenses and contact lens clean- ing solutions and, beginning in December 1981, intraocular lenses. Other examples of transitional devices include cardiovascular grafts, bone ce- ment, absorbable sutures, and specific types of immunological tests. “New” postamendments devices are also con- centrated in a few medical specialties, but not to the extent that ophthalmic devices have domi- nated approved transitional devices. Among these new devices are cardiac valves, heart pacemakers and accessories, cardiovascular catheters, life- support monitoring systems, implantable infusion pumps, artificial hips, and antibody tests for in- fectious agents. From 1977 through the end of 1982, 128 Class III products (53 “new” devices and 75 “transi- tional” devices) had gained premarket approval. During the same period, 1,007 Class III products were approved for marketing through the find- ing that they were substantially equivalent to preamendments Class III device types (compare tables 35 and 36). As previously noted, evidence of safety and effectiveness has not yet been re- quired for these postamendments Class III prod- ucts found substantially equivalent to preamend- ments devices. Many of these applications for postamendments Class III devices are for modifi- cations of devices which were already commer- cially available. Postmarketing Surveillance There are a number of existing and potential methods to monitor hazards associated with the use of devices that have been marketed. FDA maintains a Device Experience Network (DEN) that receives voluntary reports on device hazards; can require repair, refund, or replacement of de- vices for hazards or defects; and requires that manufacturers keep records of complaints as part of the good manufacturing practices regulations. Two other methods have been mentioned earlier. A condition of approval for new Class III devices approved through the full premarket approval process is that information that manufacturers re- ceive on device defects and adverse reactions has to be reported to FDA within 10 days. And man- ufacturers, importers, and distributors of devices may be required to provide FDA with informa- tion to ensure that their devices are safe and ef- fective. The major issue in postmarketing surveillance activities has involved the authority that the 1976 amendments gave to FDA to require that infor- mation be provided to FDA to ensure that devices already on the market are safe and effective. In late 1980, FDA proposed rules for mandatory de- vice experience reporting, under which manufac- turers and distributors of medical devices would be required to submit reports on devices that: 1) may have caused a death or injury, 2) may have a deficiency that could cause a death or injury or that could give inaccurate diagnostic information that could result in improper treatment, or 3) are the subject of a remedial action by the manufac- turer (307). Any death that might have been caused by a device would have had to be reported within 72 hours of the manufacturer's or distrib- utor’s receipt of that information, with a followup report submitted within 7 working days. Reports also would have had to be submitted within 7 working days after receiving information of any actual or possible device deficiency that could re- sult in a death or injury. Ch. 5—Regulation of Medical Devices by the Food and Drug Administration © 115 FDA's rationale for a mandatory device report- ing regulation was twofold. Practitioners and users of medical devices usually do not report de- vice experiences to FDA but instead contact the manufacturer for information and advice. Reports would be required even if the manufacturer deter- mined that the death or injury was not due to the device or that there was no deficiency, because FDA expected that few devices would be charac- terized by their manufacturers as having deficien- cies, few reports would be submitted, and report- ing of confirmed deficiencies would be delayed if manufacturers first investigated before report- ing (307). A year later, in late 1981, the proposed rule was held in abeyance because of comments that the requirements were overly broad and because of issuance in early 1981 of Executive Order 12291 on “Federal Regulation,” under which regulatory actions are to be taken only when the potential benefits of the action outweigh the potential costs. FDA also announced that it would inspect com- plaint files maintained under the good manufac- turing practices regulations to determine if they could be used as an adequate or partial substi- tute for the proposed rule (309). A pretest, phase I of the review of good manufacturing practices complaint files was completed on December 31, 1981, and phase II started on July 14, 1982, in- volving a review of the complaint files of 418 firms. In May 1983, FDA issued a reproposal on med- ical device reporting, under which reports would be required within 15 days of receiving informa- tion that “reasonably suggests, or a person alleges and the manufacturer or importer is aware of the allegation” that one of its marketed devices “has caused or contributed to” a death or serious in- jury or “has malfunctioned” and, if the malfunc- tion occurs, “is likely to” cause or contribute to a death or serious injury (318). Data analysis of the phase II review of good manufacturing practices complaint files had been completed by early 1984, and the report was ex- pected to be available sometime in 1984. FDA has concluded that the good manufacturing practices complaint files would not be an adequate substi- tute for a mandatory device reporting regulation for several reasons. First, inspection of complaint files would not lead to timely reporting. Good manufacturing practices inspections are conducted every 2 years, and FDA did not expect more frequent inspections in the future. Second, with over 6,000 establish- ments to inspect, there would be a problem with deciding which and how many establishments to inspect. Third, the way in which good manufac- turing practices records are kept would lead to practical difficulties in collecting the information for adverse experience information. As a conse- quence, FDA expects to reissue a revised man- datory device reporting proposal in 1984, subject to clearance by the Office of Management and Budget and other Federal agencies (257). FDA, in its proposals for a mandatory device reporting regulation, has stated that its voluntary reporting system—the Device Experience Net- work, or DEN—is not an adequate substitute. DEN is not a comprehensive reporting program, and FDA does not have the resources to main- tain constant contact with all device users to en- courage reporting. Furthermore, device manufac- turers are the most knowledgeable about their products and their associated risks and are in the best position to report to FDA. But few manu- facturers report under the DEN system, and many of the reports that they make are trade complaints about a competitor's product, not reports from the manufacturers of the devices in question. And in some cases, device manufacturers report device problems to FDA only after a product recall or other remedial action is completed (318). Reviews of DEN data on Class III devices and of recalls prompted by a hazard with a high likelihood of serious injury or death resulted in the following observations (based on information provided OTA by FDA for the period from 1976 to mid-1983). From the DEN system: deaths al- legedly associated with devices were reported most frequently for pacemakers and heart valves; actual injury, reported most frequently with pace- makers, heart valves, IUDs, and to a lesser de- gree but still relatively frequently, with intraocular lenses; and potential injury, reported most fre- quently with resuscitation equipment (usually associated with power failure or other electrical malfunction), intra-aortic balloon pumps or cath- eters, pacemakers, heart valves, and intraocular lenses. 116 ¢ Federal Policies and the Medical Devices Industry Recalls prompted by risks of serious injury or death were most frequent for cardiovascular de- vices, with pacemakers again comprising the largest subgroup. Thus, the DEN system and recalls for high risks mostly involve implantable devices, often involve electrical problems, and often involve cardiovascular devices. The DEN system of voluntary reporting and product recall information do not provide ade- quate information on the magnitude and frequency of device-related problems. Voluntary reporting also includes allegations of death or injury that may not be associated with the device in ques- tion or may be user-related and not due to de- ~ vice defects. FDA also cautions against using DEN for trend analysis, because reports are voluntary, use of the system has changed over time, and the number of reports therefore may reflect trends in —~DEN participation and other factors (48). How- ever, voluntary reporting does provide indications of the types of devices that have associated risks, and product recall information identifies devices with significant actual or potential risks. Other Provisions of the Law Restricted Devices Section 520(e) of the Medical Device Amend- ments added a provision for “restricted devices” authorizing FDA to issue regulations imposing restrictions on the sale, distribution, or use of devices. FDA was also authorized to regulate advertising of restricted devices and to inspect manufacturers’ records related to restricted de- vices. Prior to the amendments, the sale and dis- tribution of some devices were authorized only through “prescriptions” by designated persons (e.g., physicians) (21 CFR pt. 801.109). Immedi- ately following the enactment of the law, FDA published a notice announcing that FDA consid- ered “restricted devices” to include all “prescrip- tion devices” (303). When FDA attempted to inspect the records for some prescription devices, however, some man- ufacturers refused to comply, claiming that FDA had to first issue regulations designating prescrip- tion devices as restricted devices. The U.S. District Courts involved in resolving this issue ruled for the manufacturers, and both the First Circuit and Second Circuit of the U.S. Court of Appeals af- firmed the decisions of the lower courts (30,171). As a consequence, FDA decided to issue a reg- ulation rather than attempt to establish through further litigation its authority to inspect records for restricted devices. The proposed rule on restricted devices was published in October 1980 (305). However, FDA withdrew the proposed rule in November 1981, stating as its reasons: 1) comments that the cur- rent prescription device regulation was sufficient, and 2) the February 17, 1981, Executive Order 12291 on “Federal Regulation” that required Fed- eral agencies to undertake regulatory actions only when the potential benefits of the action to society outweigh the potential costs. FDA also stated that it would use the authority for inspection of records required by the good manufacturing practices reg- ulations, as well as the dispensing and labeling requirements of the prescription device regula- tions, in lieu of a restricted device regulation (309). Banned Devices The banned device provision of the law has been used once. Prosthetic hair fibers intended for implantation into the human scalp were banned in June 1983 (319,324). Color Additives FDA has not issued regulations on the color ad- ditive provisions of the amendments, but the issue has so far been limited primarily to tinted con- tact lenses. All contact lenses that are required to have premarket approval are also subject to the color additive provisions of the law. FDA initially approved tinted contact lenses even though the color additives had not been listed for that use before the applications were approved (317). When FDA subsequently concluded that it had to apply the color additive provision to tinted con- tact lenses, it decided that the least unfair method was to complete action on the pending PMAAs and to enforce the provision with future PMAAs (323). FDA is also developing proposed changes in the procedural regulations for color additives to govern their use in all applicable devices (323). Ch. 5—Regulation of Medical Devices by the Food and Drug Administration e 117 Export of Devices FDA regulations have not had a great effect on export of medical devices, because most exported devices are those that are legally marketed in the United States and require no special FDA ap- proval. Most devices requiring FDA approval for ex- port are devices that require but have not yet re- ceived premarket approval. The requirement that the importing country approve imports posed some problems because of the possibility that there might not be an official who could give ap- proval. For that reason, FDA has accepted, in lieu of an express approval, a statement from the foreign government that it has no laws prohibiting importation of the device in question. From Oc- tober 1, 1981 through March 31, 1983, 376 med- ical devices were approved for export, 13 devices were disapproved, and 1 previous approval was rescinded (181). Assistance to Small Manufacturers Both the prevalence and absolute magnitude of regulatory costs increase with establishment size, DISCUSSION AND CONCLUSIONS The principal provisions of the statute and FDA's activities have been catalogued above. The 1976 Medical Device Amendments attempted to regulate medical devices in proportion to a de- vice's degree of risk through a number of pre- and postmarketing controls. The amendments placed immediate regulatory priority on significantly new devices while providing a grace period before substantial evidence of safety and effectiveness had to be provided for preamendments Class III devices and their postamendments equivalents. Section-by-section descriptions and analyses of the major provisions of the Medical Device Amend- ments and their implementation by FDA were provided above to yield an understanding of the experience so far with the regulation of medical devices. The analysis also identified specific reg- ulatory actions that have been proposed as alter- natives to the current situation. However, iden- but the costs of regulations appear more unfavor- able to the small manufacturer when costs are con- sidered in proportion to establishment size (197). For example, in a limited study of 30 companies manufacturing only cardiovascular, anesthesiol- ogy, or diagnostic products, both initial and re- curring costs per employee were higher for small plants (fewer than 100 employees) than for larger plants (100 or more employees) (17). Small manufacturers also are more likely to need assistance in complying with the regulatory requirements. FDA's Office of Small Manufac- turers Assistance has received favorable reviews by manufacturers. In a survey of medical device manufacturers, over three-quarters had heard of the office, about half of those who had heard of it contacted it, and more than three-quarters of those contacting the office had found it helpful (197). tifying specific regulatory areas and analyzing the current approaches (and limitations) and their alternatives are not the same as developing strat- egies (including maintaining the status quo) for medical device regulation. The relative signifi- cance of actions that could be taken in specific areas of medical device regulation is hard to de- termine and justify without relating these actions to more specific strategies than the general rubric of meeting safety and effectiveness objectives at minimal regulatory costs. In the following analysis, the principal issues . that have arisen in implementing the Medical De- vice Amendments of 1976 are examined. Areas to be discussed include: ® the scope of medical device regulation, e regulation of preamendments Class III de- vices and their postamendments equivalents, 118 e Federal Policies and the Medical Devices Industry e regulation of intermediate classes of devices, ® postmarketing controls, and ¢ impact of the amendments on medical device firms. Scope of Medical Device Regulation FDA has exempted firms from certain require- ments of the 1976 Medical Device Amendments; under FDA's IDE regulations, for example, a distinction is made between “significant” and “nonsignificant” risk devices, and sponsors of in- vestigations of nonsignificant risk devices obtain an IDE from an institutional review board rather than from FDA (see section on “Investigational Device Exemptions,” above). The law also ex- pressly permits FDA to exempt firms from noti- fying FDA about their intent to market selected devices, and FDA has done so for selected types of Class I devices, subject to minimal recordkeep- ing requirements. The Scientific Apparatus Makers Association had petitioned FDA to drop notification require- ments for Class I devices, claiming that Class I devices would still be subject to the registration requirements and surveillance under the good manufacturing practices regulations. FDA subse- quently denied the petition on the grounds that the legislative intent was to make decisions on the basis of generic types of devices, and not whether or not devices were in a specific class (see section on “Premarket Notification,” above). Rather than being considered on the basis of the present statute's legislative intent, the proposal for dropping notification requirements for Class I devices could be reconsidered in a reassessment of the statute. With over 7,000 device establish- ments registered with FDA, listing approximately 41,500 products representing over 1,700 device types, one important question that arises is whether the scope of present device regulation is too broad. Not only could regulatory costs be excessive when information is gathered that is not going to be used, but other activities undertaken to help assure safety and effectiveness could be curtailed because of competition for funds within a limited FDA budget. Regulation of Preamendments Class lll Devices and Their Postamendments Equivalents As of early 1984, classifications had been com- pleted for device types in 11 of the 19 medical spe- cialty categories, and proposed regulations, most initially issued in 1982, had been issued for those in the remaining 8 (see table 34). As preamend- ments Class III devices and their postamendments equivalents cannot be required to show substan- tial evidence of their safety and effectiveness un- til at least 30 months after final classification, it will be 1986 at the earliest before manufacturers of devices in the eight medical specialty catego- ries without final classifications can be required to show that their products are safe and effective. FDA could have expedited classification of high-priority device types within each medical specialty category instead of waiting to classify all devices within each category. For example, the classification process for device types that had been provisionally designated Class III could have been completed first, thereby starting the clock on the 30-month grace period. On the other hand, the medical specialty cate- gories for which FDA first issued final classifica- tions (see table 34) include the categories in which most of the deaths and injuries were found in a review of the literature by the Cooper Commit- tee before the amendments were enacted—i.e., cardiovascular (heart valves, pacemakers) and obstetrics-gynecology (IUDs). Devices in these categories continue to be the major causes of death or serious injury as reported in FDA's voluntary DEN reporting system (see section on “Postmar- keting Surveillance,” above). Thus, the medical specialty categories for which FDA has completed classification include those categories containing devices with the highest known risks. Related to classification of preamendments de- vices is the regulation of similar postamendments devices through application of the “substantial equivalence” clause and the practice of “equiva- lence creep” or “piggybacking” whereby a post- amendments device can be found “substantially equivalent” to another postamendments device that had been previously found to be substantially Ch. 5—Regulation of Medical Devices by the Food and Drug Administration e 119 equivalent to an actual preamendments device. ~One issue is the safety and effectiveness of post- | amendments Class III devices that have been per- mitted to be marketed through the “substantial equivalence” route, because the preamendments devices against which they have been compared have yet to be required to show evidence of their - safety and effectiveness. After the 30-month grace period for preamend- ments devices expires, if FDA requires evidence of safety and effectiveness for their continued mar- keting, more evidence on safety and effectiveness will be available on the preamendments devices with which postamendments devices are com- pared. Each manufacturer of a Class III device, whether pre- or postamendments, would have to submit a PMAA if required, because FDA can- not consider the evidence of safety and effective- ness in one application when reviewing another device, even one that was previously found sub- stantially equivalent. As discussed earlier, FDA has initiated pro- ceedings for some preamendments Class III de- vices for which the grace period has ended and which FDA has determined have the highest need for evidence of safety and effectiveness (e.g., the implanted cerebellar stimulator). Criticisms of the pace at which FDA classified preamendments devices, which determines when evidence of safety and effectiveness of preamendments Class III devices could be required, could have been muted if the classification process had been speeded up for preamendments Class III devices in all cate- gories. Final classification of preamendments devices is no longer a major issue, however, be- cause classifications have already been proposed for those medical specialties without final classif- ication (see table 34), and final classification should occur soon. The remaining issues are: 1) what type of safety and effectiveness evidence should be required for preamendments Class III devices; and 2) how the “substantial equivalence” clause should be applied by FDA. FDA, in announcing its intent to require safety and effectiveness evidence for those pre- amendments Class III devices it has identified as having high priority, indicated that it intended to ask for data of the type needed for premarket ap- proval of new postamendments Class III devices (321). However, for less controversial preamend- ments devices, more flexibility in the types of evidence that have to be provided may be appro- priate. As for the application of the “substantial equivalence” clause, other interpretations or other methods of approving postamendments Class III devices are possible (see “Policy Options” section below). As noted above, the regulations that FDA has issued on IDEs distinguish between “significant risk” devices, for which sponsors have to receive express approval from FDA to conduct studies under an IDE, and all other Class III devices, of whose testing FDA need not be actually informed and which are considered to have approved IDEs subject to certain conditions (see section on “In- vestigational Device Exemptions,” above). This distinction reflected express statutory authority and a decision by FDA that risks from Class III devices varied and monitoring of testing should reflect the degree of risk. FDA has also indicated that IDEs will be made available to manufacturers of preamendments Class III devices so that they can continue to mar- ket their devices if they cannot provide reason- able assurance of safety and effectiveness when FDA requests such information. In its “Notice of Intent to Initiate Proceedings to Require Premarket Approval of Preamendments Devices,” FDA has stated that within 90 days of the issuance of a final regulation, a PMAA must be filed or commercial distribution has to cease. But an alternative for the manufacturer is to obtain an IDE and continue distribution for the limited purpose of obtaining safety and effective- ness data from clinical trials. In addition, under section 515(6) of the amendments, FDA can ex- tend the grace period if it finds that “the continued availability of the device is necessary for the pub- lic health” (321). The rationale for this use of the IDE is weak. Manufacturers of preamendments devices have had years to prepare to substantiate the safety and effectiveness of their devices, because the law was passed in 1976, the classification process is still not over, and there is a 30-month minimum grace period from the date of final classification. 120 ¢ Federal Policies and the Medical Devices Industry Regulation of Intermediate Classes of Devices For several reasons, Class II designation has probably received the most attention. First, Class II represents the important middle ground of the whole regulatory approach. Second, the majority of device types have been placed in Class II (more than 1,000 out of over 1,700; see table 34). And third, no performance standards have yet been issued. Regardless of whether or not the 1976 statute requires, rather than permits, the use of perform- ance standards, the fact remains that, as a prac- tical matter, there is little possibility that stand- ards can be formulated for the large number of device types that have been placed in Class II. If performance standards were meant to be selec- tively used, the designation of so many device types as Class II and the resulting perception of the futility of such an exercise have been damag- ing to FDA's efforts, no matter what the rationale. At the least, the present situation points out the need for an intermediate regulatory class, the in- appropriateness of mandatory performance stand- ards as the sole or even principal method of reg- ulation, and the need for other methods of regu- lating intermediate devices. There are, of course, many ways of regulating an intermediate class of devices. The principal issues here are: 1) whether a change in the stat- ute is needed before FDA can use other than per- formance standards, and 2) what types of regu- latory controls could be used. Postmarketing Controls Postmarketing controls on medical devices are of two types: 1) removal from the market or restrictions on the sale, distribution, or use of des- ignated devices; and 2) postmarketing surveillance of the clinical experiences with medical devices. FDA can remove a device from the market by requiring repair, refund, or replacement; by ban- ning it; or by revoking any approval to market the device. There are two types of restrictions on the sale, distribution, or use of a device. The first is a restriction to prescription sale or use, applied when adequate labeling for lay use cannot be writ- ten or when special skills or training are required, such as diagnosing a disease or condition or pre- scribing for treatment. The second is a restriction based on other conditions FDA may prescribe in regulations in order to provide reasonable assur- ance of the safety and effectiveness of the device. The restricted device regulations were with- drawn by FDA with the explanation that the prescription device regulations were adequate. In addition, Executive Order 12291 requires that Fed- eral agencies undertake regulatory actions only when the potential benefits outweigh potential costs. However, in the original proposed regula- tion, FDA had stated that (305): . . . the current determination that a device is a “prescription” device is quite subjective. Often, the determination is made by the manufacturer. FDA therefore proposed the restricted device rule to make these criteria more objective. FDA also stated in its withdrawal of the pro- posed restricted device rule that it would use its inspection authority under the good manufactur- ing practices regulations to inspect manufacturers’ records on these types of devices for information on such matters as deaths and injuries (309). But the Subcommittee on Oversight and Investiga- tions of the House Energy and Commerce Com- mittee observed that (338): . . most of the general controls . . . are geared toward ensuring that finished devices, when ready for use, will be free from defects, safe and effec- tive. Restriction, on the other hand, can address problems with a device once it is in use. It deals with the risks that practitioners, technicians, or others who employ the device are doing so im- properly due to inadequate training, experience, facilities, or instructions. These issues—use of existing sources of infor- mation on deaths and injuries, and problems aris- ing from improper use of medical devices rather than from improper manufacture—have also been involved in the debates on the types of postmar- keting monitoring activities that should be con- ducted. One of the expressed reasons why mandatory device reporting regulations have been held in abeyance was to examine whether the complaint Ch. 5—Regulation of Medical Devices by the Food and Drug Administration e 121 files which are required under the good manufac- turing practices regulations could partially or completely substitute for the mandatory device reporting regulations. As described earlier, the ex- amination had been completed by early 1984, with ) ( the conclusion that the good manufacturing prac- | tices complaint files are not adequate substitutes | for mandatory reporting (257). On the question of improper use, the General Accounting Office has recommended that FDA's voluntary DEN reporting system be revised so that information is included on the scope and nature of device problems caused by user error and inadequate maintenance; that the data be analyzed to identify special problems, areas where problems might be concentrated, and trends; and that the results be used to aid in developing solu- tions. FDA responded that these recommenda- | tions would be taken into consideration and that possible actions would include implementing | educational programs or restricted use criteria | (331). Thus, FDA may eventually issue restricted de- vice regulations, subject to the current adminis- tration’s position on deemphasizing regulatory ap- proaches and its preference for voluntary initiatives. Furthermore, efforts may be made to upgrade the voluntary DEN system and disseminate that information to educate users about potential hazards. Impact of the Amendments on Medical Devices Firms The preceding analyses examined individual provisions of the 1976 Medical Device Amend- ments and their implementation by FDA. A broader issue is the impact of the amendments on the med- ical devices industry. Information available on the impact of the law reflects regulatory implemen- tation by FDA and understanding of the law by device firms in the first few years following pas- sage of the statute. In evaluating this impact, it is important to keep in mind that some sections of the amendments have been implemented fully, some partially, and some have yet to be addressed. Two studies that FDA conducted to establish “baseline conditions” in order to track changes 25-406 0 - 84 - 9 that occur in the future were summarized earlier, based primarily on 1977 data (391,392). These studies showed that the “medical devices indus- try” is quite heterogeneous. There is a clear sep- aration of the industry into medical device versus diagnostic testing firms, with little overlap be- tween manufacturers of either type of product. The medical device portion of the industry is further separable into establishments that are highly specialized and those that manufacture devices in several areas. Sixty-four percent of manufacturers made devices in only one device area. Highly specialized areas include dental, oph- thalmic, and radiological devices. Each device type is made by an average of nine different manufacturers, but this measure of “prod- uct availability” or “concentration” in the indus- try is related to the class of the device. Class I de- vice types averaged 13.1 manufacturers per type; Class II, 7.9 manufacturers; and Class III, 4.5 manufacturers. Devices made by only one or two manufacturers (“exclusive” devices) comprised 28 percent of all device types and followed a similar pattern. Only one or two establishments were manufacturing 41 percent of the Class III device types, compared to 28 percent of Class II device types and 24 percent of Class I device types. Large establishments were more likely to make: 1) more device types, 2) an “exclusive” device, 3) a Class III device, or 4) a “critical” device (defined by FDA as requiring more rigorous controls in the manufacturing process). These findings lead to the following observa- tions. First, the distinction between firms that manufacture diagnostic tests and firms that man- ufacture other medical devices probably reflects the “catchall” nature of the 1976 Medical Device Amendments, which essentially authorized Fed- eral regulation over all medical products that are not drugs or biologics. One question is the ap- propriateness of regulating such distinctly different products in a similar manner. For example, Class III medical devices are generally those that are im- planted or have life-support or life-sustaining functions, and criticisms of FDA's application of the law to devices of this nature have been raised when FDA has chosen not to place some of these types of devices in Class III (253). 122 e Federal Policies and the Medical Devices Industry On the other hand, diagnostic tests pose few direct risks, but some have been placed in Class [11 because defective tests could lead to erroneous treatment (or no treatment), which in turn could result in harm to patients. The underlying ques- tions are whether the law's scope and application are appropriate, and if not, whether regulation of diagnostic tests and other medical devices can be addressed differentially under the present law or whether new legislative remedies should be ex- plored. Second, it should be remembered that the find- ings that devices in higher regulatory classes have fewer manufacturers per device type and that larger manufacturers are more likely to manufac- ture devices in a higher regulatory class represent the situation that was already present before the amendments were implemented. Classification under the 1976 amendments did not cause but might be expected to reinforce this situation, espe- cially for Class III devices, because of the higher costs associated with approval. FDA also commissioned a survey conducted in the fall of 1981 of medical device manufacturing establishments that had been registered with FDA in September 1980 (197). The surveyors concluded that there was no evidence that the amendments raised barriers to market entry, reduced innova- tion, or adversely affected investment, sales, or employment. For example, one of the survey's conclusions, based on information provided by the surveyed manufacturers, was that there was no evidence that patent activity had measurably declined since the Medical Device Amendments were enacted in 1976. Figures 2 and 3 provide a more comprehensive picture of medical device patent activities, sum- marizing patent applications with the U.S. Pat- ent Office between 1968 and 1979. Patent applica- tions on “low-technology” devices such as bandages, receptacles, eyeglass frames and lenses began lev- eling off just prior to the 1976 amendments. But applications for “high-technology” devices such as implants, dialysis machines, respiratory de- vices, and cardiovascular devices continued to in- crease throughout the decade (see app. D) The 1981 survey commissioned by FDA found that a third of all manufacturers had entered the medical device field after the 1976 statute (197). Most manufacturers reported increases in domes- tic and foreign sales, research and development (R&D) activities, and the number of new devices introduced since the amendments. Fifty-one per- cent were more profitable and only 27 percent less profitable than they had been prior to passage of the amendments, and 80 percent were optimistic about doing business in medical devices during the next decade. The survey also found that significant R&D activities were common traits in medical device firms—whether they were large, medium, or small—and that the introduction of significantly new medical devices had been just as common for small firms as for large firms (197). But when the survey was conducted in the fall of 1981, only a quarter of small establishments (1 to 9 employ- ees)—as compared to 63 percent of establishments with over 500 employees—reported that they would consider developing and marketing a Class III device. The surveyors concluded that Class III designation appears to be more likely to discour- age small establishments than large establishments from developing new devices, but observed that opinions do not necessarily translate into behav- ioral differences. They pointed out that 8.4 per- cent of establishments were manufacturing Class III devices and that a higher percentage of manu- facturers would continue developing Class III devices. Somewhat in contrast with the overall optimis- tic picture of the industry just presented were manufacturers’ answers to the survey question of the impact of the Medical Device Amendments (197). Nearly half (46 percent) stated that Federal regulation had been a major problem for them, and 21 percent stated that regulation was the single most serious problem. However, although most manufacturers wanted changes in the regu- lations, they did not believe (53 percent) that de- vice regulation should be abolished, and the vast majority (80 percent) believed that at least im- plants and life-support or life-sustaining devices should be strictly regulated. The specific problems associated with regula- tion under the 1976 amendments were varied (197). One problem reported by a substantial Ch. 5—Regulation of Medical Devices by the Food and Drug Administration e 123 Figure 2.—U.S. Patent Applications for Low-Technology Medical Devices, 1968-79 1,200 U.S. origin Foreign origin 1,000 — 800 6001 Patented applications per year 400 — 200 p~ 1972 1973 1974 1975 1976 1977 1978 1979 Year of application SOURCE: U.S. Department of Health and Human Services, Food and Drug Administration, Office of Economic Analysis, Rockville, MD, compilation of unpublished data from the U.S. Patent and Trademark Office, December 1983. 1968 1969 1970 1971 124 e Federal Policies and the Medical Devices Industry Figure 3.—U.S. Patent Applications for High-Technology Medical Devices, 1968-79 700 U.S. origin Foreign origin 600 — 500 400 300 Patented applications per year 200 100 — 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 Year of application SOURCE: U.S. Department of Health and Human Services, Food and Drug Administration, Office of Economic Analysis, Rockville, MD, compilation of data from the U.S. Patent and Trademark Office, December 1983. Ch. 5—Regulation of Medical Devices by the Food and Drug Administration e 125 number of manufacturers in the 1981 survey was the cost of compliance. In order to meet the reg- ulatory requirements, 64 percent either added new employees, purchased new equipment, or increased outside purchases. Absolute costs increased with establishment size, but when adjusted for estab- lishment size, smaller manufacturers had rela- tively higher costs per employee in meeting the regulatory requirements. Another problem reported by a significant number of manufacturers was in understanding what to expect from FDA in meeting the regula- tory requirements. Of particular interest is the cor- relation between manufacturers’ attitudes toward FDA and their understanding of the regulations. Of those manufacturers who said they fully un- derstood the regulations, about half (51 percent) gave FDA a positive rating, and 71 percent stated that the regulations were effectively protecting the public. The Office of Small Manufacturers Assist- ance was one FDA information source that was positively received by the industry, but difficulty — in understanding the regulatory requirements was still a major problem and fell disproportionately on small manufacturers. Thus, a particular pri- ority for regulatory reform was in special efforts | to improve manufacturers’ understanding of the |_device regulations. Despite the negative opinions by manufacturers regarding regulation, majorities still reported that registration, product listing, product classifica- tion, labeling requirements, premarket approval, and IDEs had no effects on their establishments (197). Seventeen percent of manufacturers even reported that good manufacturing practices have been of help to them. — Under the 1976 amendments, difficult and com- | plex precedent-setting decisions have been made | on a diversified industry that was not previously | subject to a great deal of FDA regulation. In gen- | eral, the 1976 Medical Device Amendments have not had a significant negative impact on the man- ufacturers of medical devices. Particular segments of the industry may be more affected than others, however, and compliance costs affect small man- ufacturers relatively more than they do large man- ~ufacturers. In the contact lens industry, the issues of the costs of complying with regulations and small manufacturers’ entry into the market have con- verged (see discussion under “Reclassification of Devices” section, above). Class III designation of new types of contact lenses (soft lenses, gas- permeable lenses) has made it difficult for many small companies to gain early entry because of the costs of gathering clinical evidence on safety and effectiveness. But there has not been a unified front by the contact lens industry against Class III designation. Rather, large firms that already have market approval have tended to resist reclas- sification from Class III to Class I or II. At issue in this instance is competition between first en- trants into the market and subsequent manufac- turers. The public policy goals that are at odds are rewarding companies that first succeed in get- ting innovations on the market versus achieving greater availability of products of a particular type, with price competition as one result. Throughout the medical devices industry, one of the impacts of medical device regulation has been uncertainty over the regulatory require- ments. This situation, in retrospect, is under- standable, given the fact that the implementation Photo credit: Bausch & Lomb SOFLENS, Professional Products Division The new generation of contact lenses, such as the soft con- tact lens show on the left, are subject to the full premarket approval process of the Food and Drug Administration. The older types of hard contact lenses, such as that shown on the right, no longer have to go through the full premarket ap- proval process. 126 Federal Policies and the Medical Devices Industry of some provisions of the law has not been initi- ated or completed and the fact that the majority of devices have been placed in Class II, despite inability to proceed with the statutory intent of regulating this class of devices through perform- ance standards. Conclusions During the 8 years since the Medical Device Amendments of 1976 were enacted, the medical devices industry has continued to grow, and while regulatory costs have been incurred, regulation has generally not had a significant negative im- pact on the industry. A large part of the indus- try’s development may be due in part to FDA's implementing the 1976 law in ways that would make market entry easier—as in use of the 510k premarket notification and a finding of “substan- tial equivalence” as the predominant route for devices to be released for marketing—and in part to FDA's not implementing or implementing slowly some of the law’s provisions. The situation for industry may change if FDA implements all of the provisions of the amendments, or as new medi- cal devices are developed that make it harder over time to use the “substantial equivalence” route to market devices. Several provisions of the amendments that are targeted at specific risk categories—such as those pertaining to the safety and effectiveness of pre- amendments devices, regulation of Class II de- vices, and monitoring of devices once they are on the market—have yet to be fully implemented or addressed. Yet there is little information that ac- tual risks are systematically occurring or not be- ing addressed by FDA's choice of priorities in im- plementing the amendments. This paucity of information on actual risks can be interpreted in two ways, based on opposing POLICY OPTIONS Most of the attention that has been focused on medical device regulation since the enactment of the 1976 Medical Device Amendments has been oriented toward questions such as whether a par- assumptions. First, it might be taken as an indica- tion that hazards are in fact low, that the current application of the amendments is satisfactory, and that it is not necessary to implement all of the law's provisions. An alternative interpretation is that the paucity of information on risks is a defi- ciency in itself —one that the amendments attempted to address—and that a lack of information on risks is a problem that needs to be addressed. The Medical Device Amendments provided more effective methods for dealing with fraud- ulent devices, and the increasingly complex nature of “high-technology” medical devices was one of the imperatives for developing premarket screen- ing and testing requirements. Public policy in these two instances was not primarily dependent on quantifying the number of injuries currently caused by medical devices. In the case of fraud- ulent devices, the amendments provided more ef- fective tools for removing these devices from the market. For “high-technology” devices, the amendments attempted to anticipate and minimize potential risks associated with their use through pre- and postmarketing controls. Realistically, however, it might be expected that debates over how and to what extent medical devices should continue to be regulated will focus on the costs to industry versus (lack of knowledge of) the ex- tent of risks associated with medical devices. In sum, 8 years after the Medical Device Amend- ments of 1976 were enacted, the medical device industry has incurred regulatory costs but con- tinues to prosper in general; major sections of the law remain partially or not implemented, and there do not seem to be any obvious, major risks that are not being addressed, a situation that may reflect either a lack of significant risks or lack of knowledge of significant risks that do exist. ticular provision of the 1976 law has been imple- mented, whether its implementation has been compatible with congressional intent, and whether the provision worked in practice as it did in con- Ch. 5—Regulation of Medical Devices by the Food and Drug Administration e 127 cept (331,338). A range of options proposed for specific issues that the current law was designed to address is provided below. Areas of the law to be specifically addressed include: ¢ evaluating the safety and effectiveness of preamendments devices and their postamend- ments equivalents, ¢ developing performance standards for Class II devices, ® reviewing postmarketing activities and con- trols, and e assisting small manufacturers of devices. Beyond developing options on specific provi- sions of the law, however, there is the question of how specific actions fit within an overall reg- ulatory framework. Various overall regulatory approaches are presented in the first three options below. Scope of Medical Device Regulation Option 1: Continue the basic framework and in- tent of the 1976 Medical Device Amendments and make adjustments in implementation or wording of the specific provisions of the law. A judgment could be made that the basic frame- work and intent of the 1976 amendments remains appropriate and that the law's implementation by FDA should proceed, subject to modifications in the wording or implementation of specific provi- sions of the law that reflect judgments on the appropriate balance between methods of ensur- ing safety and effectiveness and the costs associ- ated with these methods. FDA, in implementing the 1976 law, has had to develop a set of priorities so that its limited resources could be efficiently applied. Congress could provide more direction to FDA on what it considers priority issues and what orientation it considers appropriate within a particular regula- tory area. Setting such priorities would entail weighing benefits to consumers from reducing risks and ensuring efficacy versus costs to the in- dustry from regulatory requirements. Examples of priority areas might include approval of new devices, particularly Class III; safety and effec- tiveness of preamendments Class III devices; selec- tive monitoring and controls over marketed de- vices; and development of better information on device-associated risks. Congress could also provide direction within each priority area on the extent of its concern about ensuring safety and effectiveness versus minimizing barriers to market entry. Approaches to balancing safety and effectiveness versus ease of marketing are reflected by the variation in the types of safety and effectiveness evidence that could be required for preamendments Class III devices and in whether FDA or device manufac- turers should bear the burden of proof (see Op- tions 4, 5, and 6). A different strategy from focusing on which provisions of the law should be emphasized would be for Congress to determine which aspects of the current law do not have high priority. The ex- emption of devices from some of the law's re- quirements through the use of FDA's discretionary authority has been previously discussed. FDA has exempted manufacturers of some Class I device types (e.g., specimen containers) from having to notify FDA when they intend to market their devices and from most of the recordkeeping re- quirements of the good manufacturing practices regulations. In the regulations on IDEs, FDA makes a distinction between “significant risk” and “nonsignificant risk” Class III devices and requires different procedures for the two. Also mentioned earlier was a petition to FDA from the Scientific Apparatus Makers Association, subsequently denied by FDA as being against legislative intent, to drop 510k notification requirements for all Class I devices. Option 2: Revise the 1976 Medical Device Amend- ments to reflect the status quo with regard to FDA's implementation of the law. Although the issuance of mandatory perform- ance standards for Class II devices has proved not to be feasible and FDA has yet to complete the implementation of several other provisions of the 1976 law, obvious, systematic deficiencies in the safety and effectiveness of medical devices have not been apparent. One approach, therefore, might be to recognize the two-tiered regulatory approach that has been applied to medical devices rather than the three-tiered approach originally built into the law. 128 Federal Policies and the Medical Devices Industry More flexibility could be obtained through the kinds of controls identified previously to augment or replace Class II performance standards (see Op- tion 13), but the bedrock of the law could be limited to: 1) general controls for all devices, and 2) premarket approval requirements for a limited number of devices, such as implantable or life- supporting devices. Other current provisions could also be modified or deleted. For example, review of preamendments devices could be limited to high-priority device types, the approach that FDA is currently taking. Option 3: Revise the 1976 Medical Device Amend- ments to exclude certain device types from reg- ulation. In the previous option, revisions in the law would be guided by FDA's implementation of the law to date. In addition to or in place of that op- tion, Congress might choose to consider statutory exclusions of some device types. Statutory medifications could be guided by focusing on risks, such as the proposal to exempt Class I devices from notification and recordkeep- ing requirements, or by focusing on the variety of medical products currently under the jurisdic- tion of the amendments, such as the question of whether it is appropriate to regulate diagnostic tests in the same manner as other types of medi- cal devices. Regulation of Preamendments Devices and Their Postamendments Equivalents The 1976 amendments provided a 30-month grace period after final classification before evi- dence of the safety and effectiveness of preamend- ments Class III devices would be required by FDA. For these devices, two issues that remain are what type of evidence has to be presented and when that evidence has to be provided to FDA. In part, these issues are important because of the wide- spread use of the “substantial equivalence” method of gaining market entry for postamendments devices. As previously discussed, a finding of substantial equivalence will be made if a new de- vice does not differ markedly as to materials, design, or energy source, and if there is no sig- nificant difference with regard to safety and ef- fectiveness. As yet, however, there is no require- ment to provide safety and effectiveness evidence on the preamendments devices with which new devices claimed to be their substantial equivalents are compared. In addition, FDA's Office of General Counsel does not consider a finding of “substantial equi- valence” an approval. A device is considered ap- proved once a determination is made that it is safe and effective. The 510k method of obtaining FDA's permission to market a device is basically a determination that the device is substantially equivalent to a preamendments device, and FDA has no choice but to allow it to be marketed; it is not a determination that the device is safe and _ effective (464). ISSUE: What evidence of safety and effectiveness should be required of preamendments Class III devices? Option 4: Continue FDA's current approach of emphasizing safety and effectiveness evidence for high-priority preamendments Class III devices. Under FDA's current policy as represented by this option, preamendments Class III device types with questionable safety and effectiveness or with relatively high risks will be addressed by FDA first, using expert opinion and publicly available literature. This approach can be viewed as a rea- sonable allocation of FDA's limited resources, al- though FDA has to gather and review informa- tion to set areas of priority, and developing the information can be very resource-intensive for FDA. Option 5: Limit through legislation requirements for evidence of safety and effectiveness of pre- amendments Class III devices to device types that have specific problems associated with them. This option would codify FDA's current ap- proach so that FDA would have to identify pre- amendments Class III device types with problems before it could require evidence of safety and ef- fectiveness. Other preamendments device types Ch. 5—Regulation of Medical Devices by the Food and Drug Administration ¢ 129 would be presumed to be safe and effective, sub- ject to development of new information. As in the previous option, this approach could be resource- intensive for FDA because the agency would have to gather evidence to identify problem devices. Legislating this approach instead of relying on FDA's discretion would reduce uncertainty and make it explicit that all preamendments Class III devices will not eventually have to show evidence of safety and effectiveness. Option 6: Encourage FDA to accept evidence of safety and effectiveness such as reviews of the literature and expert opinion, in lieu of clini- cal evidence, for preamendments Class III devices. In the two previous options, the safety and ef- fectiveness of preamendments Class III devices would in effect be presumed, and FDA would de- velop information to counter that presumption before initiating actions. In this option, the bur- den of providing FDA with evidence of safety and effectiveness would continue as now to rest with the manufacturers, but the range of acceptable types of evidence would be greater. This approach would enable FDA to screen all device types or a greater number than would the two previous options, and the screening process might then be used by FDA to target problem devices. A variation of this option would be for FDA to start with the presumption that clinical data on devices are required but allow manufacturers to overcome that presumption with evidence gained from general use of these types of devices. ISSUE: When should safety and effectiveness evidence be required of preamendments Class III devices? Option 7: Continue FDA's interpretation that the end of the 30-month grace period after final classification establishes the earliest date that FDA can require safety and effectiveness evi- dence on preamendments Class III devices. Because the 30-month grace period establishes the earliest date on which the agency can act, FDA has begun the process of requiring safety and ef- fectiveness evidence for only a few “high-priority” preamendments Class III devices. FDA's priority- based review is dictated by the limited resources available to FDA and the resulting difficulty in calling for evidence of safety and effectiveness for all preamendments Class III devices as their grace periods expire. Thus, the issue of when such evidence will be required is related to the ques- tion of what kinds of evidence will be acceptable (see Options 4, 5, and 6). Option 8: Establish the end of the 30-month grace period after final classification as the time when FDA has to call for safety and effectiveness evidence on preamendments Class III devices. This option could be legislated, but its desir- ability depends on whether FDA takes other ap- proaches to ensuring safety and effectiveness as discussed above and on the resources FDA could devote to preamendments devices relative to other provisions of the law. For example, if FDA takes the approach in Option 6 of accepting a greater range of evidence to screen for problem devices, this option would be much more reasonable to implement than under current conditions, in which FDA has assumed responsibility for iden- tifying problem areas. Option 9: Prohibit use of the IDE to extend the grace period for preamendments Class III de- vices that have been required to show evidence of safety and effectiveness, except when no acceptable alternatives are available. The grace period for many preamendments devices had not ended or had not even begun as of early 1984, 8 years after the amendments were passed. Given this extended period of “notifica- tion,” there seems little justification for making IDE routinely available to preamendments device manufacturers. Possibly, however, IDEs could be made available on a case-by-case basis. Routine use of the IDE to continue limited distribution of preamendments devices would be less of an issue if other types of evidence of safety and effective- ness, such as literature reviews and expert opin- ions, were accepted. Except for those options specifically calling for legislation, all of the options pertaining to pre- amendments Class III devices could be imple- mented under the existing statute. However, Con- gress could mandate a particular approach through legislative changes. 130 * Federal Policies and the Medical Devices Industry ISSUE: Does the “substantial equivalence” method of entering the market for postamendments medical devices need to be revised? The 1976 Medical Device Amendments require that any postamendments device not found “sub- stantially equivalent” to a preamendments device be automatically classified in Class III, with subse- quent opportunity to petition for reclassification of the device in Class I or II. The “substantial equivalence” clause of the 1976 law was meant to make a regulatory distinction between those postamendments devices that are modifications of commercially available devices from those that are truly new devices. Because of the costs and delays in approval associated with the reclassification process, how- ever, manufacturers of postamendments devices have had incentives to seek a finding of “substan- tial equivalence” rather than reclassification so that they can market their devices much sooner. Much less information is needed to successfully claim that a postamendments device is substan- tially equivalent to a preamendments device than to gain approval through the premarket approval process. In fact, the lack of information on the safety and effectiveness of preamendments devices raises questions about how determinations of substantial equivalence can be made. Option 10: Retain existing procedures for deter- mining “substantial equivalence.” As previously explained, FDA has begun to call for safety and effectiveness evidence on high- priority preamendments Class III devices, and once that evidence is presented and evaluated, there should be a substantive basis for compar- ing these devices with postamendments devices determined to be substantially equivalent. But the process will take years and may be selective rather than including all preamendments Class III devices. On the other hand, the “substantial equiva- lence” clause has been a convenient method for device manufacturers to get their products onto the market quickly. But as new generations of postamendments devices diverge more and more from their preamendments antecedents, it will be harder for manufacturers to use the substantial equivalence method of market entry. It will also be harder to practice “piggybacking,” in which a postamendments device is compared to another postamendments device and, through a chain of other postamendments devices, eventually com- pared to a preamendments device. More immediately, FDA's Office of General Counsel has stated that such “piggybacking” is not authorized by the amendments (464), and if the practice of piggybacking ceases, more postamend- ments devices will eventually be placed in Class III, and their manufacturers will have to go through the full premarket approval process or petition FDA for reclassification. Option 11: Eliminate automatic classification into Class III of postamendments devices that are not found substantially equivalent to preamend- ments devices, and allow FDA to place a de- vice in the appropriate class at the time of notification. Automatic classification into Class III of post- amendments devices that are not found substan- tially equivalent to preamendments devices serves as a second screen in the regulation of post-1976 devices. The first screen is a determination of whether or not a device is “substantially equiva- lent” to a preamendments device. The second screen, with automatic classification into Class III, is a presumption that any device that is not sub- stantially equivalent needs full premarket ap- proval, unless the manufacturer successfully peti- tions FDA for reclassification in Class I or Class II. Under this option, the burden of responsibility of coming forth with evidence that rebuts initial Class III designation could remain with device manufacturers, but manufacturers could be al- lowed to present this evidence for classification at the time of notification. This change should re- duce current incentives to claim “substantial equivalence.” Option 12: Develop approaches for reviewing new devices that are different from those for review- ing modifications of commercially available devices. Ch. 5—Regulation of Medical Devices by the Food and Drug Administration e 131 Eliminating automatic Class III designation of postamendments devices that are not found sub- stantially equivalent to preamendments devices might serve to bring out the distinction between modified and new devices that the “substantial equivalence” clause was originally meant to pro- vide. GAO has recommended another approach, eliminating the “substantial equivalence” clause so that all Class III (but not Class I or II) post- amendments devices have to go through premar- ket approval. (Automatic Class III designation for non-substantially equivalent postamendments de- vices could also be eliminated so that new devices that would more appropriately be put into Class I or II would not have to go through the super- fluous step of reclassification.) In general, then, the difference in approach could be between pre- and postamendments devices as originally in- tended, or between Class III pre- and postamend- ments devices, where the difference in regulatory requirements is most pronounced. Regulation of Class Il, or Intermediate, Devices More than 1,000 of the 1,700 device types have been placed in Class II. The unanimous opinion, however, is that except for a small number of de- vice types, performance standards cannot be de- veloped in a timely fashion. Thus, if an inter- mediate class of regulation is still needed, per- formance standards will have to be replaced by other types of regulation between Class I and its good manufacturing practices requirements and Class III and its premarket approval requirements. Option 13: Give FDA legislative authority to use available methods in addition to performance standards to regulate Class II devices. An obstacle to the use of methods for regulat- ing Class II devices other than performance stand- ards has been the question of whether or not the law requires the use of performance standards. GAO has in fact suggested that the law be revised to give FDA the authority to make a device-by- device determination of when performance stand- ards are needed (331). Although the use of per- formance standards may not be mandatory, a change in the statute clearing up the ambiguity might be useful in setting into motion substan- tive efforts to use other approaches, instead of continuing to focus attention on the unrealistic expectation that so many performance standards can be developed. FDA has suggested using a combination of voluntary standards, user education, and other existing controls to regulate Class II devices (387). Previously identified controls include revoking any approval to market a device, banning the de- vice, or requiring repair, refund, or replacement, and the prescription and restricted device provi- sions. If the legality of using available approaches in place of performance standards is upheld or the use of these remedies legislated, a three-tiered reg- ulatory system for medical devices can be put in place. Rather than a Class II with mandatory con- trols, however, there would be specific devices (Class I or Class III) for which additional controls could be stipulated (e.g., prescription or restricted devices), and device-by-device determinations of the applicability of these other controls. Option 14: Legislate an additional category of Class II devices to be regulated through meth- ods other than performance standards. The Subcommittee on Oversight and Investiga- tions of the House Committee on Energy and Commerce has suggested that performance stand- ards be retained for Class II and that a Class IIA be formed on which greater controls (e.g., restric- tions under the restricted device clause, increased mandatory device experience reporting, and adop- tion of performance specifications against which the device must be tested periodically) are imposed (338). This option is similar in effect to the previous option, the principal difference being that this op- tion involves legislating an explicit, additional cat- egory of Class II devices and retaining mandatory performance standards for some devices. Also, this option would leave less discretion to FDA in determining which devices should be regulated and how they should be regulated. Option 15: Encourage FDA to reclassify most Class II device types into Class I or III and to continue to develop performance standards for the remaining Class II devices. Rather than being regulated through perform- ance standards, medical devices receiving Class 132 e Federal Policies and the Medical Devices Industry II designation are currently being regulated by FDA as though they were Class I devices. A par- tial approach to the problem might be to screen current Class II devices to see whether some of them could be placed in Class III. This issue was raised by the Health Research Group in the case of General and Plastic Surgery devices, when FDA proposed placing seven implantable device types (including artificial ears, noses, and chins) in Class II rather than Class III (253). The burden of regulation under Class III for reclassified Class II devices might not be onerous. FDA already differentiates between “significant risk” and “nonsignificant risk” Class III devices in its IDE regulations, and FDA could develop dif- ferent levels of evidence for safety and effective- ness of the types previously discussed under op- tions for preamendments Class III devices (Option 6). Postmarketing Monitoring and Controls The lack of information on risks associated with the use of medical devices can be viewed either as evidence that such risks are not extensive and that more vigorous device regulation is not needed, or instead as an indication that monitoring sys- tems should be improved to yield more informa- tion before risks are discounted. Identifying prob- lems is crucial in determining which devices may need additional controls and what types of con- trols should be applied. Thus, improved informa- tion on risks would be helpful both for determin- ing the scope of the problems that regulation could address and in applying the appropriate types of controls. Option 16: Require FDA to develop better sys- tems for monitoring and providing information on risks associated with devices. FDA is reportedly ready to make final its reg- ulations on mandatory device experience report- ing by manufacturers, subject to the Office of Management and Budgets approval (257). GAO has suggested that FDA's voluntary reporting sys- tem, the Device Experience Network (DEN), be revised so that information is included on the scope and nature of device problems caused by user error and inadequate maintenance; that the data be analyzed to identify special problems and trends; and that the results be used to aid in de- veloping solutions (331). GAO is also initiating a comprehensive exploration of postmarketing surveillance activities and their potential applica- tions (300). Thus, there is a gradual movement toward bet- ter identification of, and faster and more targeted responses to, device risks. The process might be accelerated by legislating mandatory device ex- perience reporting instead of continuing with the permissive language contained in the statute. Option 17: Encourage FDA to selectively apply postmarketing controls to regulate Class II devices. Postamendments controls could be applied to a new class of Class II devices or left to be ap- plied by FDA on a device-by-device basis (see Op- tions 13, 14, and 15). A reconstituted three-tiered classification approach would result. Minimal reg- ulation would apply to the lowest class of devices through the good manufacturing practices regu- lations. An intermediate class of devices (Class II) would be represented by those devices that have additional controls (prescriptions, restricted devices, postmarket controls) applied to them of the types identified in addition to the good man- ufacturing practices requirements. The highest regulated class of devices would have to meet premarket approval requirements and might have additional controls imposed on their marketing. Assistance to Small Manufacturers The 1976 amendments contained a provision to help small firms through the regulatory proc- ess by establishing an Office of Small Manufac- turers Assistance. Two other steps could aid small firms in manufacturing Class III devices: 1) where appropriate, Class III devices could be down- classified as soon as possible; and 2) small firms could be given assistance in developing the safety and effectiveness evidence necessary for Class III device approval. Option 18: Develop additional mechanisms to help small firms through the regulatory process. Option 18A: Encourage FDA to use publicly available information as soon as possible to down-classify Class III devices. Ch. 5—Regulation of Medical Devices by the Food and Drug Administration ¢ 133 FDA could take the initiative in identifying Class III devices of significant importance to pub- lic health and could monitor their use. Thus, pub- licly available information could be accumulated at the earliest possible time and down-classifica- tion could be initiated. Option 18B: Develop a “broker” mechanism be- tween small firms with promising devices and clinical investigators capable of performing the tests necessary to gather safety and effective- ness data in support of the premarket approval application for Class III devices. Although Option 18A might help small firms gain approval for medical devices that are already on the market, it would not help small firms that want to be among the first to have their devices approved for marketing. There is some precedent for a broker function, although there might be questions of conflict-of- interest if FDA assumed the role. One precedent, for example, is the past and continuing collabora- tion between commercial sponsors and specific in- stitutes at the National Institutes of Health in per- forming clinical trials for potentially significant new drugs to meet FDA's requirements of clini- cal testing for premarket approval. Another prece- dent is the Federal promotion of “orphan” medi- cal products, in which Federal funds are used to support clinical trials for promising products that have a limited market, such as drugs for rare dis- eases. Thus, as a broker, FDA could maintain a registry of potentially marketable devices and pro- vide it to interested parties. . . 0 Lo : . a = a . ow a : So La : a oe a a . . a - = . = oo . . 6. Regulation of the Providers of Medical Devices INTRODUCTION Regulation in health care has developed because of certain conditions that set the health care field apart from many others. Large segments of the American public do not have sufficient medical knowledge to make informed decisions about their health care. To a significant extent, therefore, especially in the case of sophisticated procedures and unusual medical conditions, patients must rely on the judgment of physicians or other health care professionals. Furthermore, as described in chapter 3, the system of third-party financing for medical care that has evolved in this country has fostered the uncritical adoption and sometimes ex- cessive use of medical technologies, including medical devices. Such adoption and use, in turn, have contributed to a rapid rate of increase in Fed- eral expenditures under programs such as Medi- care and Medicaid and in national health care ex- penditures generally. Chapter 5 discussed the Food and Drug Admin- istration’s regulation of drug and device manu- facturers to protect the public from unsafe and ineffective drugs and medical devices. This chapter examines regulations pertaining to the health care institutions and individuals—i.e., hospitals, nursing homes, home health agencies, ambulatory surgi- cal centers, clinical laboratories, and others—that provide or use major medical equipment, such as computed tomography (CT) scanners, or smaller devices, such as sutures or splints. Various Federal and State regulatory programs affect the providers of medical devices. As noted in the discussion that follows, regulation of health care providers has been undertaken with several objectives in mind: e that people receive care of acceptable quality, e that rising expenditures on health care are controlled, and e that the distribution of medical facilities is equitable. This chapter analyzes the impact of Federal and State regulation of providers on adoption and use of medical devices in specific health care deliv- ery sites. It also discusses interactions among the regulations and proposed changes. Although deci- sions to adopt and use medical devices are typi- cally made by physicians, most of the regulations discussed in this chapter affect physicians only in- directly. FEDERAL REGULATION OF PROVIDERS At the Federal level, providers of services to Medicare beneficiaries are regulated through con- ditions of participation, section 1122 of the Social Security Act, and professional standards review organizations (PSROs) (currently being replaced by the utilization and quality control peer review organizations, PROs). Providers are also regu- lated under State laws required by the Federal health planning program. 25-406 O - 84 - 10 Federal Regulation of Providers Under Medicare Designers of the Medicare program wanted to ensure that the Federal Government paid for good quality care for elderly and disabled people eligi- ble for benefits under this program (107), and conditions of participation for providers were adopted at the outset of the program to attain a 137 138 e Federal Policies and the Medical Devices Industry satisfactory level of quality. As the program was implemented and costs rose, cost containment also became an issue. Thus, in the Social Security Amendments of 1972 (Public Law 92-603), both to help ensure beneficiaries’ access to quality med- ical care and to help contain costs, Congress cre- ated the PSRO program and added section 1122 to the Social Security Act. Along with conditions of participation, PSRO review of the utilization and quality of services provided to Medicare ben- eficiaries and section 1122 review of capital ex- penditures are described further below. Conditions of Participation Conditions of participation are requirements that must be met by hospitals and other providers in order to receive payment for treating Medicare or Medicaid patients. The purpose of the condi- tions is to assure a basic level of quality of the medical care for which the Federal Government pays (107). The conditions of participation for hospitals are similar to the voluntary standards promulgated by the Joint Commission on Accred- itation of Hospitals (JCAH) (see box L) or the American Osteopathic Association. About 5,200 hospitals accredited by JCAH or the American Osteopathic Association are automatically con- sidered in compliance with Medicare quality standards. However, an additional 1,495 hospi- tals are not accredited by either of these organi- zations but do participate in Medicare or Medic- aid (315). Some conditions of participation for providers list specific medical devices whose availability is required. The lists of devices in conditions of par- ticipation are generally not extensive or exhaus- tive, but instead allow providers flexibility in deciding which services to make available. Hos- pital operating suites, for example, must have the following equipment available: call-in system, car- diac monitor, resuscitator, defibrillator, aspirator, thoracotomy set, and tracheostomy set (42 CFR 405.1031 (a) (II)). Freestanding ambulatory sur- gical centers must provide laboratory and radio- logic services that include, but are not limited to, such medical devices as surgical dressings, splints, casts, appliances, materials for anesthesia, and diagnostic or therapeutic services directly related to the provision of surgical procedures (42 CFR 416.46 (c)). The conditions of participation have not under- gone any substantial revision since Medicare began operating in 1966. Revisions proposed by the Department of Health and Human Services (DHHS) in January 1983 would make the condi- tions of participation for hospitals less prescrip- tive, allowing hospital medical staff and admin- istrations greater flexibility in the provision of inpatient medical care. Statutory requirements are still included, but the proposed changes “. . . are intended to simplify and clarify requirements, to focus on patient care, to emphasize outcome rather than the means used to achieve those ends, to promote cost containment while maintaining quality care, and to achieve more effective com- pliance with Federal requirements” (315). Bene- ficiary and labor groups have protested the new regulations, and the Secretary of Health and Human Services has delayed publication of the final rules by returning them to the Health Care Financing Administration (HCFA) (452). Many of the existing conditions of participa- tion for providers specify educational and experi- ence requirements for personnel, similar to JCAH standards. Stringent personnel requirements can have several effects on the diffusion of medical devices. Requirements for highly trained (and therefore often expensive) personnel to perform certain tasks give providers such as clinical lab- oratories incentives to purchase capital equipment that reduces the number of personnel required to perform the task (provided the available person- nel are already being used efficiently) (120,227). If such capital equipment is expensive, hospitals and facilities that provide services to inpatients must comply with section 1122 of the Social Secu- rity Act and State certificate-of-need (CON) reg- ulatory programs required by the National Health Planning and Resources Development Act of 1974 (Public Law 93-641). These Federal and State pro- grams, discussed further below, were responses by policymakers to several problems: the duplica- tion of facilities and services, which contributed to the high cost of health care; access to health care, especially as it pertained to the maldistribu- tion of services; and the high cost of medical care Ch. 6—Regulation of the Providers of Medical Devices © 139 140 e Federal Policies and the Medical Devices Industry borne by Medicare and Medicaid. The interaction of various Federal and State regulations for in- dependent clinical laboratories is described in box M. The effects of Medicare conditions of partici- pation on the adoption and use of medical devices are unclear. Initially, there was an impetus for the Federal Government to approve as many hospi- tal beds as possible so that the Medicare guaran- tee of access to medical care for elderly people would be operational on the first day of the pro- gram’s implementation (7,107). In some cases, hospitals that had not previously been accredited because of failure to meet “contemporary stand- ards of technology, staffing, and medical prac- tice” were certified by Medicare as “in substan- tial compliance” (107). The incentives for facilities to achieve full compliance were weak, because hospitals with conditional certification were paid on the same basis as those in full compliance. Since Medicare conditions of participation for hospitals were based on JCAH accreditation stand- ards, any evidence on effects of the voluntary JCAH standards would apply to these conditions as well. Unfortunately, there is little evidence that accreditation has had an impact on the quality of care in hospitals or on the adoption of new medical technologies (227). Whether or not the conditions of participation affect the adoption and use of specific medical devices is impossible to prove because of the general lack of specificity regarding medical devices in most of the condi- tions of participation (and in the JCAH stand- ards). Data sources for comparisons also lack specificity regarding medical equipment. Medicare's diagnosis related group (DRG) based prospective payment system for hospitals, which was mandated by the Social Security Amend- ments of 1983 (Public Law 98-21) and is currently being implemented (see ch. 3), changes the envi- ronment for Medicare-based regulatory programs. Medicare's DRG hospital payment system may enhance the importance of conditions of partici- pation for quality of care. The same law that man- dated DRG payment also added a new “condi- tion of payment”: In order to be paid for treating Medicare patients, hospitals must contract with PROs (see “Utilization and Quality Review Pro- grams’ section below). Utilization and Quality Review Programs Utilization review programs in hospitals have been a condition of participation for hospitals par- ticipating in Medicare since the program's incep- tion in 1966. In the original Medicare legislation, hospitals were required to have periodic reviews of the medical necessity of admissions, extended stays, and professional services rendered (42 CFR 405.1035 (a)). The purpose of these reviews was to help contain costs and to ensure quality of care. Medical device use was to be evaluated in con- nection with the review of professional services. Congress mandated the PSRO program in the Social Security Amendments of 1972 (Public Law 92-603) to carry out these utilization and quality review responsibilities. PSROs, which as noted above are currently being replaced by PROs, are areawide groupings of practicing physicians des- ignated by DHHS to review services provided to Medicare and Medicaid beneficiaries. Their pur- pose has been to ensure that the services Medi- care and Medicaid pay for are: 1) medically nec- essary, 2) of a quality that meets locally deter- mined professional standards, and 3) provided at the most economical level consistent with quality of care. Thus, the two objectives of the PSRO pro- gram have been quality assurance and cost con- tainment (345). In theory, PSROs were to accomplish these goals by conducting three types of evaluations in inpatient hospital settings, long-term care facili- ties, and ambulatory care settings: e utilization reviews (e.g., reviews of the length of stay and medical necessity of admissions); ¢ medical care evaluations or quality review studies (e.g., audits of patient records to monitor the appropriateness of tests, drugs, and procedures administered to patients); and e profile analyses (e.g., reviews of hospital physicians’ patterns of care to identify po- tential problems). In practice, PSROs have tended to emphasize utilization reviews in inpatient settings, focusing on the identification of high hospital admission rates and lengths of stay. One of the reasons is that identifying high usage of hospital care has proved easier than identifying underuse of hos- Ch. 6—Regulation of the Providers of Medical Devices ¢ 141 142 eo Federal Policies and the Medical Devices Industry pital care or specific medical technologies. Fur- thermore, from the standpoint of reducing Medi- care costs, reducing overutilization of hospital admissions and lengths of stay is clearly impor- tant. Reducing overutilization of hospital care is likely to be more cost saving than reducing under- utilization, although it could be argued that from the standpoint of quality assurance, it is also im- portant to consider the latter. PSRO utilization reviews in hospitals, although not focused on particular drugs, devices, or med- ical procedures, may nevertheless have indirectly affected the utilization of specific medical devices. Quite conceivably, changes in hospital admission rates and lengths of stay may have indirectly af- fected the use of diagnostic tests and other device- based procedures routinely used for hospital patients. Like PSRO utilization reviews, most medical care evaluations and profile analyses have been conducted by PSROs in inpatient hospital settings. Unlike utilization reviews, however, some medi- cal care evaluations have been directly focused on the appropriate use (including underutilization) of specific medical devices. Thus far, evidence on the effectiveness of re- view programs has been mixed. Analysts consid- ering benefits of review programs have examined both cost savings and contribution to quality assurance. Evidence is inconclusive that utiliza- tion review programs have achieved net cost sav- ings when reductions in length of stay and admis- sions are considered along with the costs of the review program (50,57,325,326,334,395,397,409, 411). Evidence that review programs have im- proved quality of care is limited but suggestive (57,395). No specific evidence of the effects of PSRO or hospital review programs on the adoption and use of medical devices has been reported, although a study of one hospital showed that length of stay and average charges per patient (probably related to medical device use) generally decreased follow- ing institution of PSRO review. The decrease, however, did not result in savings to Medicare and Medicaid because of an increase in hospital admission rates also attributed to PSRO review (455). As noted earlier, the Social Security Amend- ments of 1983 added as a new “condition of pay- ment” for hospitals treating Medicare patients the requirement that hospitals contract with PROs. PROs have responsibility for monitoring ancil- lary service use and hospital discharges that re- sult in quick readmissions, because Congress rec- ognized the financial incentives under DRG pro- spective payment to use as few ancillary services (including those involving medical devices) as pos- sible, to discharge Medicare patients as quickly as possible, and to admit as many cases as possible. PROs, the replacements for the PSROs, are contract organizations that must affirm their uti- lization review and quality assurance objectives, as well as define their specific plans on how to attain these objectives, in their contracts with HCFA. Medical devices will be subject to evalua- tion under the PRO function to review the com- pleteness, adequacy, and quality of care to hos- pital inpatients. A specific requirement in the scope of work for PROs is to monitor cardiac pacemaker implantations and reimplantations for unnecessary procedures (407). Section 1122 Capital Expenditure Review Section 1122 of the Social Security Act and State CON laws required by the National Health Planning and Resources Development Act (see “Federal Health Planning Regulations” and “State Certificate-of-Need Laws” sections below) poten- tially could have the most direct effect on medi- cal devices of any of the provider regulations dis- cussed in this chapter. Congress mandated section 1122 capital expenditure review in the Social Secu- rity Amendments of 1972 (Public Law 92-603). The purpose of section 1122 review is to ensure that Federal funds for Medicare, Medicaid, and the Maternal and Child Health and Crippled Children’s Services programs are not used to sup- port unnecessary capital expenditures by health care facilities. Section 1122 of the Social Security Act authorized the Secretary of Health, Educa- tion, and Welfare (now Health and Human Serv- ices) to enter into contracts with States that were willing and able to do so. Under these contracts, a State or State health planning agency would re- view expensive capital expenditures, and the Sec- Ch. 6—Regulation of the Providers of Medical Devices ¢ 143 retary could withhold reimbursement for expend- itures that were disapproved. Under section 1122, capital expenditures by specified health facilities that exceed a certain threshold—initially $100,000, currently $600,000— are subject to review by a State or State planning agencies. Also subject to section 1122 review are changes in numbers of beds or substantial changes in the services offered in medical care facilities. As of 1983, only 15 States had contracts with DHHS to conduct section 1122 capital expendi- ture reviews. Section 1122 currently applies to hospitals, psychiatric hospitals, tuberculosis hospitals, skilled nursing facilities, kidney disease treatment centers, intermediate care facilities, and ambulatory sur- gery centers. Medicare and Medicaid reimburse- ment to these facilities can be denied only for unapproved capital expenditures (i.e., expenses related to depreciation, interest on borrowed funds, or, in the case of proprietary facilities, re- turn on equity for capital equipment or construc- tion). Reimbursement for operating expenses asso- ciated with unapproved capital equipment or construction is not affected. Because of the high threshold for section 1122 review and the State-based decisionmaking proc- ess provided for in the law, the effect of section 1122 provider regulation on medical devices is probably similar to that of the State CON pro- grams required by the National Health Planning and Resources Development Act of 1974 (see sec- tion on “State Certificate-of-Need Laws” below). Only a few devices—e.g., CT scanning and nu- clear magnetic resonance (NMR) equipment—ex- ceed the threshold for section 1122 review. Thus, most purchases of medical devices by the facili- ties to which section 1122 applies can be made without section 1122 review. Federal Health Planning Regulations Bringing together several strands of previous legislation, the National Health Planning and Resources Development Act of 1974 (Public Law 93-641) outlined national health priorities and replaced the existing network of voluntary agen- cies with a system of about 200 local health sys- tems agencies and State health planning and de- velopment agencies. The purpose of this act and related health planning legislation was to cen- tralize decisionmaking at the State level in order to rationalize resource allocation and control escalating rates of cost increases. The 1974 law called for the provision of greater authority to State and local planning agencies over hospital investments. The law required State health planning agencies to review CON and sec- tion 1122 applications from medical facilities regarding capital investments. State planning agencies have the responsibility of determining the numbers and types of facilities and services needed by their populations. State Health Plans to accom- plish the equitable distribution of these health care services are required by the Federal law. Agen- cies try to alleviate the perceived maldistribution of health services and to contain rising costs through CON programs. Amendments to the 1974 National Health Plan- ning and Resources Development Act established a two-level review process for CON programs. A medical facility must submit a detailed applica- tion to the local health planning agency, which subsequently reviews it. State health planning agencies have the authority to grant a CON, but they must carefully consider the recommendation of the local agency. Minimum criteria and standards for CON re- view Dy the States are set forth in the Federal plan- ning law. The State agencies must consider the relationship of the proposed services to the State health plan and to the provider's long-range plan, the targeted population's need for the proposed services, alternative means of meeting the need, the availability of resources for the proposed serv- ice and alternative health uses of those resources, the relationship of the proposed service to the ex- isting health care delivery system, and special needs of health maintenance organizations (HMOs), among other criteria. Current Federal law requires hospitals, skilled and intermediate-care nursing facilities, kidney disease treatment centers, rehabilitation hospitals, and freestanding ambulatory surgical centers to submit applications for capital expenditures under State CON programs. States vary in their cover- 144 e Federal Policies and the Medical Devices Industry age of other facilities, but few cover physicians’ offices (see section on “State Certificate-of-Need Laws” below). Some facilities are exempt from the Federal requirement for CON applications for capital equipment, among them Federal hospitals and clinics (e.g., Veterans Administration medi- cal centers). Medical research institutions and HMOs are given special consideration. These en- tities must notify the State CON agency that they intend to purchase a piece of major medical equip- ment, for example, and the agency must approve the purchase if specific applicant criteria are met and if need is demonstrated (Public Law 96-79 and Public Law 96-538). Required applications for CON are triggered under Federal law by types of expenditures and by amounts of such proposed purchases. Pro- posed expenditures must: 1) exceed the threshold, 2) substantially change the bed capacity of the fa- cility, or 3) substantially change the services of the facility. The original CON thresholds were: 1) $150,000 for capital expenditures, 2) $75,000 for annual operating costs resulting from chang- ing services, and 3) $150,000 for major medical equipment to be used to provide medical and other health services. The CON threshold levels that have been in effect since 1981 are: 1) $600,000 for capital expenditures, 2) $250,000 for annual operating costs resulting from changes in health services, and 3) $400,000 for major medical equip- ment to be used to provide medical and other health services.! For changes in health services, CON applications are required if there is any cap- ital expenditure or if annual operating costs ex- ceed the specified operating cost threshold (129). Medical device purchases are included in CON applications in those instances in which the de- vices are very expensive or in which facility serv- ices are changed. Since 1979, Federal law (Public Law 96-79) has required purchases of major medical equipment that will be used for medical treatment of hospi- States have been given authority to adjust these thresholds to reflect the change in the previous year in the Department of Commerce Composite Construction Cost Index. For States that do so, the thresholds would be $695,285 and $289,782. The $400,000 threshold for major medical equipment may not be adjusted. (See Public Law 97-35 or proposed rule changes in the Jan. 4, 1983, issue of the Federal Register (315).) tal inpatients to be covered by State CON laws, regardless of who makes the capital expenditure. Gifts and donations of medical devices that would come under CON laws if they had been bought by the facility are also subject to CON requirements. Capital equipment initially purchased for re- search purposes usually must be approved for later clinical use through the CON requirement regarding new institutional services. There are no national data available regarding how much med- ical equipment has initially been purchased for re- search purposes and then transferred to clinical service. Thus, the effect of this aspect of the CON regulation on the medical devices industry is unknown. What are the sanctions or incentives that en- force the Federal planning law’s requirement that States have CON laws? First, States that do not have such laws risk losing their Federal planning money. But Federal planning funds have decreased over the past few years, and the program has weakened. Second, and probably more impor- tant, if States do not have conforming CON laws, they are supposed to lose Federal funds from sev- eral Public Health Service programs (particularly those under the Community Mental Health Centers Act, Comprehensive Alcohol and Alcoholism Pre- vention, Treatment, and Rehabilitation Act of 1970, and the Drug Abuse Office and Treatment Act of 1972—see Public Law 96-79, sec. 123(d)(2)). The threat of these sanctions persuaded all but one State (Louisiana) to pass CON laws by March 1983 (406), although as of March 1984, only 23 States had CON programs in compliance with the minimum Federal requirements (129). Because the sanctions are not being applied under the present national law, however, Minnesota, Idaho, and New Mexico have allowed their CON laws to ex- pire. For several years, the costs and benefits of the Federal planning program have been ques- tioned by Congress. This debate has resulted in funding the planning program through continu- ing resolutions that have specified that noncom- plying States not be penalized. The future of the Federal planning program is uncertain. Budget decreases and the expressed in- tention of the Reagan Administration to disman- tle planning have further weakened the existing Ch. 6—Regulation of the Providers of Medical Devices ¢ 145 Photo credit: General Electric Nuclear magnetic resonance (NMR) imaging equipment, shown here, is one of the few medical devices that is expensive enough to be regulated under State certificate-of-need (CON) laws. program. The Administration, however, seems to be reconsidering its position (453). New CON thresholds have been proposed in Congress (see box N), and the Office of Management and Budget has indicated a willingness to accept thresholds of $5 million for capital expenditures, $1 million for changes in institutional health services, and $2 million for major medical equipment (453). Al- though the fiscal year 1985 Federal budget con- tains no funds for health planning, the Adminis- tration has indicated that new, reasonable legislation would be considered favorably (37). Health planning has many critics, but an in- depth examination of the pros and cons of health planning is beyond the scope of this report. Spe- cific criticisms of the Federal health planning pro- gram focus on the difficulty of determining the need for various health facilities and services. Methods of calculating need involve the use of demographic and epidemiologic data and require decisions based on the pros and cons of having excess or insufficient facilities on a periodic or sporadic basis. State and local planning agencies often rely on hospitals and other facilities for their data, which may pose problems of reliability. In considering the need for new medical technol- ogies, data may not be available. State planning agency staffs may not have information on safety, efficacy, and cost effectiveness of new or old med- ical devices. Furthermore, agency personnel have been criticized for their lack of ability to use the data appropriately (61,111). The effect of the Federal health planning regu- lations on medical devices is most distinct in the CON impacts examined in the section on “State Certificate-of-Need Laws” below. STATE REGULATION OF PROVIDERS At the State level, providers of medical devices are regulated in part through State licensure laws for facilities and personnel. They are also regu- lated through State CON laws, which are required by the Health Planning and Resources Develop- ment Act of 1974 (Public Law 93-641) to conform to Federal criteria. Capital expenditure reviews required by section 1122 of the Social Security Act were discussed in the section on “Federal Regula- tion of Providers” above. Although like CON re- views, section 1122 reviews are State based, the sanctions on facilities for noncompliance with the section 1122 are the withholding of Federal funds under Medicaid, Medicare, and Maternal and Child Health and Crippled Children’s Services programs. The sanctions on facilities for failure to comply with CON, by contrast, are determined by individual States. State Licensure of Facilities and Personnel States have the power and responsibility to de- termine which providers may treat patients. To ensure a minimum level of quality for providers, State laws require hospitals, nursing homes, and other health care facilities to meet specific stand- ards in order to be licensed to operate. Facility 146 * Federal Policies and the Medical Devices Industry standards often include staffing requirements for licensed personnel who have met a set of licen- sure qualifications, such as education and experi- ence. Virtually all States have hospital licensure laws, but licensure laws with respect to other types of facilities vary. State licensure laws also vary according to types of personnel. The specific standards and qualifications required are decided by the individual States (227). Some licensure laws are more detailed than others regarding medical devices or, more fre- quently, necessary staffing and staff qualifica- tions. Licensure laws are similar to the Medicare conditions of participation in their focus on struc- tural aspects of quality assurance, such as com- pliance with construction codes and public health laws. Licensure regulations tend to be weaker, more ambiguous, and not so well enforced in mat- Ch. 6—Regulation of the Providers of Medical Devices eo 147 ters that are more clearly related to patient care (227). There has been little research on the influence of State licensure laws on the adoption and use of new medical technologies (227). It is probable, however, that licensure programs have had mixed effects on medical devices, depending on the speci- ficity of the individual laws and how a particu- lar device is related to personnel needs. In clini- cal laboratories, for example, the strict personnel requirements for laboratory licensure make equip- ment that reduces the number and skill level of personnel quite attractive (120). On the other hand, licensure requirements may slow the diffusion of equipment that requires li- censed personnel for operation (227). In addition, stringent rules to employ highly trained person- nel in laboratories raise barriers to entry of new facilities in the market because of the difficulty of finding and expense of employing the required personnel (120). Both facility and personnel licen- sure, then, can affect medical device diffusion. Another characteristic of State licensure pro- grams themselves that probably affects the med- ical devices industry is the use of professional surveyors to inspect facilities. The subjectivity of some of the judgments needed to decide about licensing a facility can sometimes be the basis for challenging negative outcomes. Also, if review teams have a particular professional orientation, they can encourage the adoption of the best avail- able new equipment (227). State Certificate-of-Need Laws Several States had CON laws prior to the enact- ment of the National Health Planning and Re- sources Development Act of 1974. In 1964, New York became the first State to enact and imple- ment a CON law. Twenty-seven States had CON laws by the time the National Health Planning Act was passed. These States were required by 1980 to make their laws conform to the same minimum Federal standards as State CON laws enacted after 1974 (Public Law 96-79).2 However, State CON 2Costs and benefits of the Federal health planning program have been debated in Congress for several years. This debate has led to budget cuts and to continuing resolutions that do not enforce penalties on noncomplying States. laws differ with respect to the types of facilities covered, the standards and criteria used for CON review, and the amounts of the expenditures for which CON applications must be submitted (406). As noted in the “Federal Health Planning Reg- ulations” section above, current Federal law re- quires hospitals and other specified medical fa- cilities to submit applications for capital expend- itures under State CON programs. Some States require other types of facilities (e.g., freestanding emergency care centers and home health agencies) to submit applications, as well. Nine States re- quire CON applications for equipment purchases for physicians’ offices (453). The focus of review when CON laws were first implemented after 1974 was on construction proj- ects (i.e., modernizing old buildings and erecting new ones) and bed capacity changes (61). One of the reasons was that control over the costs of such projects implied control over further duplication of facilities and excess bed capacity that was blamed for some of the increase in health care costs. Another reason for the focus on construc- tion and bed capacity changes when CON laws were implemented was that there were few med- ical technologies at the time that cost more than $150,000 (the original CON threshold). Further- more, hospitals and other purchasers of medical equipment were able to circumvent the require- ment for CON applications for equipment pur- chases in excess of the threshold by dividing orders into smaller expenditures that would not trigger the review process (42). If new laboratories were built or old ones renovated, construction was usu- ally necessary and put the project over the CON threshold. If equipment purchases (regardless of price) changed the health services offered, or if the new services (regardless of capital expendi- tures) resulted in operating costs over $75,000 (again, the original threshold), CON applications would be required (129). As CON programs matured and as medical equipment changed, more medical devices came under review. Highly innovative machines that altered the practice of medicine, such as the CT scanner, were introduced in the 1970s (see box O). Machines such as CT scanners presented CON agencies with difficulties because of their high cost 148 ¢ Federal Policies and the Medical Devices Industry Ch. 6—Regulation of the Providers of Medical Devices e 149 and the paucity of data on safety and efficacy. Physicians were still experimenting with new uses of CT scanners and manufacturers were still refin- ing their machines when CON agencies received applications from hospitals and other covered fa- cilities. In some cases, physicians and physician groups purchased CT scanners for their hospitals, to circumvent the requirement for CON approval (which in 1979 was extended to cover any major medical equipment to be used for inpatient care without regard to the purchaser or to the loca- tion of the equipment) (349). The interaction of CON thresholds and equip- ment purchase prices is a potential source of in- fluence on the diffusion of new medical devices. Over time, CON thresholds have increased. The prices of medical equipment also change over time as refinements are made or as components instead of a composite machine are sold, for example. The prices of medical equipment may go either up or down. If new major medical equipment is priced above the CON threshold, delaying its purchase may save a facility money (unless the facility's resulting loss in potential operating revenues is substantial): if the price drops below the CON threshold, the facility may save not only the amount by which the price drops but also the administrative costs of the CON application. In the case of equipment that substantially changes the services provided by the facility, however, CON review would be necessary even if the price were to drop. In addi- tion, facilities are prohibited from dividing proj- ects into parts to avoid CON applications—each project must be a separate project (141). Under the Federal requirements, State CON programs are to “provide for procedures and penalties to enforce the requirements of the pro- gram” (42 U.S.C. 300 m-2). Hospitals and other covered facilities must submit their CON appli- cations to the State or local planning agency and abide by the approvals or denials or suffer the consequences. Sanctions against providers vary among the States but may include any or all of the following: denial or revocation of operating licenses, fines, civil or criminal penalties, and court injunctions (42 CFR 123.408 (b)). Studies of the effectiveness of CON programs have shown that some States have used them suc- cessfully and others have not (133,436). Capital expenditures and health care costs have continued to increase despite CON laws, although both results may vary by State (436). Several research- ers have studied the effects of CON on capital ex- pansion; some have found evidence supporting capital limitation by CON and some have found evidence against it (436). Studies of the effect of CON on cost control have produced no findings to support its ability to control health costs (436). Access to care for some patients has been improved, but there still seem to be excess bed capacity and duplication of services and facilities in some areas and short- ages in others, all of which were to have been eliminated through CON (61). There have been many studies of the impact of CON programs on capital expenditures (436). One of the early studies by Salkever and Bice showed that in States with CON laws, the number of beds decreased, but total hospital investment and assets per bed (which relate to medical devices) increased from 1968 to 1972 (270). Hellinger, testing the hypothesis that the amount of hospital investment in States with CON laws would be less than it would have been without the CON programs (148), concluded that CON legislation had not significantly decreased capital expenditures. He then speculated that there would be a lagged effect because hospitals had an- ticipated the passage of the CON laws and spent higher than usual sums in the period before their implementation. Warner has pointed out that because they do not specifically consider operating costs associ- ated with capital purchases, CON programs do not evaluate whether equipment will ultimately save costs or increase costs (450). Operating costs of capital expenditures continue to be a source of health care cost increases (64). Yet another study showed that in States with hospital rate-setting programs, increased capital expenditures may not lead to higher operating costs (96). Specific devices may be affected dif- 150 e Federal Policies and the Medical Devices Industry ferently in different States. Russell found that the diffusion of cobalt therapy was not discouraged by the CON law in New York, but CON laws in other States have discouraged the technology's adoption of cobalt therapy (266). A July 1982 study by the Wisconsin Hospital Association used data from the Wisconsin Hos- pital Association CON Data Base, its 1982 CON Survey, and State and local CON agencies’ grant applications for 1978-81 to analyze the cost ef- fectiveness of Wisconsin's CON program (462). The association found, using particular assump- tions, that CON costs far outweighed the benefits. The investigators concluded that Wisconsin's CON program was not cost effective, did not sup- press applications for capital expenditures (i.e., did not have a sentinel effect), had had its deci- sions reversed through administrative appeals, and had been unfocused and inconsistent in the substance of its reviews and in its determinations. Looking at application and approval and denial data gives the impression that CON programs are accomplishing some of their goals. From 1979 to 1981, States reviewed more than 20,000 CON ap- plications, which totaled more than $31 billion. Almost 10 percent of the applications were denied, saving an estimated 15 percent of the proposed expenditures (406). These aggregate figures hide the facts that CON may have deterred an unknown number of ap- plications and purchases and that the quality of the rejected applications is unknown. Some con- sultants specialize in CON applications (148), and manufacturers may send staff to assist hospitals in their CON applications (208). Small hospitals with less sophisticated technology are probably at a disadvantage in attracting or being able to pay for such help, and this may exacerbate the maldistribution of high-technology devices. Also among the unknowns are whether the distribu- tion of services is being made equitably among the population and whether approved projects were needed more than those denied. The costs of the CON programs themselves are substantial. In 1982, total Federal and State costs of administering CON programs were $16.9 mil- lion (406). Additional costs were probably offset by the CON application fees charged by half the States. Application fees and the other costs borne by the applicant facilities may discourage some applications. Whether the applications discouraged are frivolous or important for the health of the affected population is unknown. It is likely that examples could be found at either extreme. Weighing the costs of the CON programs against their benefits is difficult because of the existence and interactions of Federal, State, and local reg- ulatory programs and of complex goals. Com- peting goals, such as the elimination of excess beds and the assurance of access to health care, not only present CON programs with problems while they are evaluating applications, but also exacer- bate the problem of identifying and measuring the benefits of regulation and planning. CON programs would lose some of their con- trol over capital expenditures if the thresholds were raised to the levels proposed by the Office of Management and Budget (i.e., $5 million for capital expenditures, $1 million for changes in services, and $2 million for major medical equip- ment). Clearly, fewer projects would require CON applications. Even some new facilities would be below the threshold unless they were specifically covered by CON laws. New freestanding emer- gency care centers, for example, have averaged $634,000 in building, land, and capital equipment costs (292). Capital expenditures that change in- stitutional services and increase operating costs by $1 million annually would still require a CON, but their numbers would probably be small. High thresholds and the resultant low number of CON applications would save administrative costs for Federal and State governments and for the fa- cilities. If the Federal health planning program expires, the State CON laws will be voluntary (as far as the States are concerned). In 1984, the Office of Health Planning of DHHS has estimated that 37 of the States that have CON laws would keep them without the Federal requirement (129). A dozen States have “sunset” clauses that allow the CON laws to expire on specific dates; some others have sunset provisions tied to the anticipated de- mise of the Federal health planning program. Again, some States have CON laws that are more stringent and some have more lenient regulations than the Federal CON requirements. Ch. 6—Regulation of the Providers of Medical Devices 151 The financial incentives for hospitals under Medicare's DRG hospital payment system cur- rently being implemented (see ch. 3) change the roles of the CON laws and the planning program in general. Some of the effects will depend on how capital costs will be handled under the DRG sys- tem.* With DRG payment for inpatient operat- Capital costs are now paid on a cost-reimbursement basis but will probably be paid on a different basis by 1986, since Congress mandated studies of how to treat capital costs under the DRG hos- pital payment system (Public Law 98-21). Any new capital payment method can be expected to change the hospitals’ incentives regard- ing capital expenditures. ing costs (capital, outpatient, and direct teaching expenses remain “passthroughs”), hospitals have financial incentives to purchase technologies that lower their operating costs per case; and if they are expensive, these technologies may come under CON scrutiny. An anticipated response to the DRG hospital payment system is the movement of technologies from tertiary to primary care sites. This movement may be retarded in States where facilities other than hospitals are included under CON. The effect of such movement on costs will depend on whether the primary sites were replac- ing or supplementing hospital care and on the ex- tent of total use that results. DISCUSSION AND POLICY OPTIONS Regulation of the providers of medical devices has been undertaken to control medical care costs, increase access to medical care (including devices), and control quality of care. Available evidence on the success that Federal and State regulation of providers has had in meeting these objectives is inconclusive. Health care costs continue to rise at a higher rate than the overall Consumer Price Index. Access to care is still a problem for some poor patients or patients in particular locations. Quality of care is difficult to define and measure, and problems remain in assessing quality concerns. Conditions of participation for providers of services to Medicare beneficiaries and the new Federal requirement that hospitals contract with PROs (utilization and quality control peer review organizations) in order to be paid by Medicare have quality as well as cost implications. Changes in conditions of participation proposed by DHHS in January 1983 would give hospitals more flex- ibility in the provision of inpatient care, and med- ical devices may be affected even less under the new conditions than they were under the original set of conditions. Efforts have been made in the PRO regulations issued by DHHS to address pre- vious problems with the PSRO program concern- ing quality review by requiring that evaluations of PROs have both cost and quality components. Evaluations of PSRO programs focused on cost- containment goals without adequately measuring quality of care. Thus, for example, such evalua- tions emphasized the ability of PSRO utilization reviews to decrease length of stay and hospital admissions. Section 1122 of the Social Security Act pertains to review of capital expenditures and the Medi- care, Medicaid, and Maternal and Child Health programs. Few medical devices come under sec- tion 1122 review because of the high threshold ($600,000). However, those devices that do also trigger CON review. The penalty for facilities that disregard section 1122 reviews would be stronger if the Social Security Act required the withholding of Federal program payments for operating costs associated with unapproved capital investments. The Federal Health Planning and Resources De- velopment Act requirement that States impose CON regulations on hospitals and other facilities in theory should have formed the strongest regu- latory mechanism concerning the adoption and use of medical devices. Although CON regula- tions have attempted to contain costs and improve access, the evidence of their effect on medical devices is inconclusive: it is unclear whether CON laws have influenced the adoption and use of med- ical devices. The results obtained by State CON laws may reflect certain characteristics of these laws. First, the laws have high thresholds for capital expend- 152 e Federal Policies and the Medical Devices Industry itures resulting in the coverage of few devices under these laws, and the laws ignore future oper- ating costs. Second, the focus on hospitals by almost all the CON laws—although other sites are covered by some States (including physician of- fices in nine States)—may have contributed to duplication of technologies within the system. Third, the lack of a limit on the amount a CON agency can approve lessens the potential impact of CON on total costs. Fourth, the CON process is a reactive process in the sense of being depend- ent on the submission of CON applications by medical facilities. And fifth, political interactions among consumer patients, providers, and CON agencies influence the decisionmaking process. One problem with concluding from the mixed evidence that CON regulations have been inef- fective is that incentives for health care facilities to buy whatever they wanted were embedded in cost-based reimbursement by third-party payers, and not all purchases were subject to CON re- quirements. Duplication of equipment among hos- pitals and other facilities in the same geographic area continues at least in part because facilities want to attract patients and physicians by pro- viding up-to-date equipment. CON programs do not have the power to decide how much equip- ment is used or the ways in which it is used. Uti- lization and quality review programs can encourage the appropriate use of technologies, but decisions about use are basically left to physicians (and in some cases patients). CON agencies have been hampered by unavail- ability of data on the health of the population and on the safety and efficacy of some new medical equipment, undeveloped techniques for determin- ing need, insufficient budgets to hire appropriate planning agency staffs, and the political sensitivity of rationing health care. Furthermore, the regu- latory agencies responsible for CON were advised by committees representing not only consumers but also the health care providers. CON decisions were thus compromises among parties with con- flicting interests. All these difficulties have been exacerbated by constantly changing technology. The following options present a range of pos- sibilities regarding CON programs, from chang- ing current regulations to eliminating them. The options concentrate on CON because of the rela- tive availability of information on these programs and because of the direct impact on the medical devices industry. Option 1: Expand the National Health Planning and Resources Development Act to require State CON laws to cover purchases of medi- cal equipment regardless of setting. This option would attempt to make the incen- tives of the Federal health planning act more neu- tral with respect to the location of certain medi- cal devices by requiring that in addition to the hospitals, dialysis centers, and other facilities now covered by the act, physicians’ offices, diagnos- tic centers, and other facilities now excluded by the legislation be required to submit CON applica- tions before purchasing expensive medical equip- ment. Control over all sites of care would remove current incentives to place expensive devices in certain, mainly nonhospital, settings without re- gard to cost effectiveness. Maldistribution of med- ical equipment might still occur, though, because of the reactive nature of the CON process and the influence of other factors on placement. Several States already have CON programs that cover major medical equipment purchases regard- less of setting or ownership. Some States are en- couraging hospitals to share equipment, such as new NMR devices in Nebraska (291). More shar- ing would be anticipated if all settings were cov- ered, especially if a State had a limit on total CON approval. If such sharing became commonplace, different arrangements might be necessary to en- sure quality (349). For example, facilities now carry liability insurance for their own physicians to use their medical devices; this type of insur- ance might have to be extended to other physi- cians using the devices. Greater administrative costs to governments and providers from increasing the number of ap- plications would result under this option. Al- though few medical devices are covered by CON thresholds, applications would increase since many of the settings that would be added by this option already purchase high-cost medical devices for which hospitals and other facilities are cur- Ch. 6—Regulation of the Providers of Medical Devices ¢ 153 rently regulated. Regulatory staff would have to learn about health care delivery and needs for devices in these currently uncovered settings. Option 2: Amend the National Health Planning and Resources Development Act to limit the level of capital expenditures that State CON agencies may approve in a year. Because the funds for health care facilities and medical devices are limited, not all projects can or should be funded. Current CON approval or denial decisions are not necessarily made in light of information on different types of projects, and tradeoffs are not necessarily considered. A limit on the level of capital expenditures would neces- sitate comparisons among projects. The Federal requirement that CON applications be batched so that similar projects are evaluated at the same time does not address the issue of tradeoffs among dissimilar projects. Hospitals that want to purchase new CT scanners, for example, may have to wait several months until the batch of applications is evaluated. Those applications are reviewed without regard to applications for other types of equipment or for buildings. The Commission on Capital Policy of the Amer- ican Health Planning Association recently recom- mended that future cost-based reimbursement for capital be limited by each State, subject to a Fed- eral standard (5). The commission urged the adop- tion of limits that reflect the relative need of each State for modernization of facilities and for new services and facilities. It further suggested that capital payments within those limits be allocated by means of a planning and capital expenditure review process, presumably similar to the existing system. If Medicare's DRG prospective payment sys- tem for hospital operating costs were extended to other payers, a State limit on total CON approval would become less useful. The reason is that hos- pital acquisitions would be constrained by the fi- nancial pressures to limit operating costs. A limit on the level of expenditures a CON agency could approve would also be less necessary if capital ex- penditures were included in DRG payments. A major obstacle to the implementation of this option is the limit itself. Congress or the Admin- 25-406 0 - 84 - 11 istration might be the decisionmaking body for choosing the limit, but how would the limit be chosen? Techniques for determining a commu- nity’s need for specific medical devices are still controversial. Determination of the need for the total capital expenditure in health care is clearly problematical. How much is the Nation or each State willing to pay overall for health care? How could that amount be apportioned between capi- tal and operating costs, excluding preventive care for the moment? Would the limit be applied na- tionally or at the State level or locally? How should the budgeted limit be apportioned among the geographic regions or among the health care delivery sites? The ultimate problem would be the selection of individual projects for funding in light of the lack of a generally valid decisionmaking method and the lack of theoretical or empirical predictions that the results of such a limit would be efficient or equitable. Option 3: Amend the National Health Planning and Resources Development Act to eliminate the Federal CON requirement. State CON programs have not been uniformly successful in controlling the costs and quality of, or improving access to, health care delivery. Health care costs are rising at a great rate, and some rural areas and urban public hospitals do not have the minimal requirements for some serv- ices that are outlined in the “National Guidelines for Health Planning” under the Federal health planning program. This option would eliminate the Federal requirement that States have CON laws, but would permit those States that wanted to continue their programs to do so. Implementation of this option would eliminate the State and Federal Governments’ administra- tive costs for the Federal program. It would also relieve hospitals—and in some States, other fa- cilities—of the costs of application fees, person- nel, and delays involved in the CON process. The method of treatment of capital expenditures by the Medicare payment system will affect the need for regulations, especially if the DRG-based prospective payment system expands to other payers. In the past, Medicare has reimbursed hos- 154 o Federal Policies and the Medical Devices Industry pitals for capital equipment on the basis of costs (see ch. 3). Medicare's DRG prospective payment system provides incentives for hospitals to reduce operating costs. If cost reimbursement for capi- tal continues under Medicare's DRG payment sys- tem, hospitals will face incentives to purchase medical devices that will reduce operating costs. If payment for capital costs is more restricted, the incentive to purchase such devices will be weakened (but not eliminated). No matter how capital costs are treated, socially desirable medical devices that raise operating costs may not be financially desirable to hospitals. CON programs could play a role in the proper diffusion of socially desirable but very expensive technologies if they could encourage particular fa- cilities to purchase such technologies by offering special treatment on other applications, for ex- ample. At present, this kind of negotiating role would require changes in some CON laws. Medicare's DRG-based prospective payment system itself may change the need for CON pro- grams or for the national planning effort, espe- cially regarding distribution of services. If the in- centives of DRG payment work as anticipated, hospitals will specialize in treating patients in those DRGs in which they are efficient. Such specialization will follow a hospital's efforts to work with its medical staff to be cost conscious and to reduce the use of very expensive services. Some hospitals will continue to try to attract phy- sicians and patients through purchases of the latest medical devices, but others will cut back some services. Specialization among hospitals is likely to re- sult from the dropping of services that do not pay for themselves through DRG payments. For ex- ample, a hospital that finds that its costs for staff, facilities, and equipment for coronary care are lower than the relevant DRG payment rates may specialize in coronary care. The same hospital may drop its pediatrics services if its costs are higher than the relevant DRG rates. Specializa- tion could decrease duplication of medical devices and possibly eliminate excess capacity and lower excess use. CON programs may become unnec- essary in light of these strong cost-containment incentives for hospitals, although the problem of duplication of services among nonhospital settings not covered by CON could be worsened. If specialization decisions were made on a purely cost basis, however, it is clear that not all serv- ices or medical devices would be available to all segments of the population: areas of low popula- tion density or low income would suffer. The cur- rent planning process has not solved the problem of inequitable distribution of facilities and serv- ices. Some communities and population groups are still underserved, while certain areas have too many hospital beds. In addition, health planning has not thus far ameliorated the problem of pub- lic hospitals, which treat a disproportionate num- ber of poor and elderly patients and which do not have the funds to renovate or to purchase neces- sary equipment. 7. Veterans Administration Policies Regarding Medical Devices INTRODUCTION The Veterans Administration (VA) has a prom- inent role in the medical devices industry from both the producer and purchaser sides of the mar- ket. Since the late 1940s, the VA has been an im- portant source of research and development (R&D) funds, notably for rehabilitative technologies. In fiscal year 1983, the VA's total R&D budget was almost $160 million, of which over $10 million was specifically earmarked for rehabilitative R&D. Actively serving about 3 million out of 30 mil- lion veterans eligible for free health care and rehabilitative services with an annual budget of more than $8 billion, this agency is a significant power in the marketplace. The VA presents a unique example of a health care system that includes the continuum of pa- tients, needs, facilities, money, and personnel and the mandate to develop, deliver, evaluate, and support a full range of devices and services. Be- cause of its size, the agency clearly has potential for influencing the medical devices industry. Yet although the VA health care system is completely funded by the Federal Government and centrally administered, decisions regarding the purchase and use of medical devices are primarily made at the clinical and VA medical center levels. Over- all, the impact of the VA on the medical devices industry reflects this combination of targeted pro- grams and policies and decentralized activities. The relationships among the parts of the VA dis- cussed in this chapter are depicted in figure 4. Throughout this chapter, medical devices are grouped and referred to in three classes: e rehabilitative devices, such as prosthetics and sensory aids for disabled people; ¢ equipment, such as radiological and labora- tory equipment; and * supplies, such as bandages and other dis- posables. The discussion begins with an overview of the VA health care system and then describes the VA's programs, activities, and policies with regard to the R&D, testing and evaluation, procurement and supply, and, finally, adoption and use of medical devices. OVERVIEW OF THE VA HEALTH CARE SYSTEM’ The VA's health care system is the largest health care delivery organization in the Nation.2 The vast majority of services are delivered to veterans in VA-owned facilities. Most acute care services are provided in 172 VA medical centers that are, for the most part, affiliated with medical schools. Unless otherwise noted, this section is adapted from a discus- sion in U.S. Congress, Congressional Budget Office, Veterans Administration Health Care: Planning for 1990, Washington, DC, February 1983 (327). 2The Hospital Corp. of America, a private, “for-profit” hospital chain, includes more facilities, but has revenues only about half the size of the VA's health care delivery budget (130). Begun after World War II, the affiliation program is generally credited with enhancing the quality of care at the VA hospitals. These hospitals oper- ated over 82,000 beds in fiscal year 1981 and treated about 1.25 million patients. The VA provides both institutional and non- institutional long-term care services. Ninety-eight nursing homes associated with the VA medical centers provide highly skilled extended care after hospitalization. The VA plans to increase the number of nursing home beds from the 8,700 beds that were operated in 1981 to over 13,000 by 1987 to serve the rapidly expanding aged veteran pop- 157 158 e Federal Policies and the Medical Devices Industry ulation. Other institutional long-term care serv- ices are provided by the VA in community nurs- ing homes, where services are purchased on a per diem basis, and at State veterans’ homes, where the VA subsidizes care through grant programs. The VA also operates 15 domiciliaries, usually on the VA medical centers’ campuses, where serv- ice-disabled or permanently disabled veterans can live and receive necessary minimal health care. Noninstitutional care provided includes day-care programs for the elderly and various home-care programs. The outpatient programs operated by the VA represent an alternative to hospitalization for many veterans. In 1981, more than 15.8 million outpatient medical visits were made to VA staff, and 2.1 million visits were made to private phy- sicians and funded on a fee-for-service basis by the VA. Clinic services are varied. In addition to diagnostic, treatment, and rehabilitative clinics, the VA operates mental hygiene clinics and day treatment centers for psychiatric patients and pro- vides dental care services for long-term care pa- tients. In all, the VA employs the full-time equivalent of approximately 194,000 physicians, dentists, nurses, and administrative and support person- nel. The VA's Department of Medicine and Sur- gery, headed by the Chief Medical Director, ad- ministers the entire health care system with an annual budget in 1983 of just over $8 billion. The Department of Medicine and Surgery is admin- istered from the VA's Central Office in Washing- ton, DC. Specific areas of patient care and pro- gram function (e.g., rehabilitation medicine, surgery, radiology, and medical research) are the responsibility of VA organizational units called services. As shown in figure 4, these units are under the guidance of service directors in the VA's Central Office. The VA's health care system operates under a limited and controlled budget with plans projected for 1 and 5 years ahead. Funding is 100 percent Federal. Once Congress determines the overall ap- propriation, the budget is fixed for the following fiscal year. However, after the appropriation level is decided, the VA health care system is charac- terized by highly decentralized planning and fi- nancial management policies. Twenty-eight re- gional areas, called medical districts, control the allocations that are prospectively budgeted by the Central Office. Each medical district is typically composed of 4 to 10 VA medical centers. The Veteran Patient Population Currently, there are an estimated 30 million veterans eligible for health care services. About 40 percent of the eligible population are World War II veterans now in their 50s or 60s. By 1990, practically all of these 12 million World War II veterans will be over 65 years old, and the VA is concerned about the impact of this aging pop- ulation on the health care delivery system. Only a small proportion of the eligible popula- tion actually uses the VA health care system, how- ever. In 1981, about 3 million veterans, or 10 per- cent of those eligible, used VA services. Most veterans use community services for their health care, presumably because they have adequate public or private health insurance or they prefer the proximity of non-VA facilities. It is estimated that only about 2 million of the World War II veterans will apply for VA health care benefits when they are over 65 years of age. Any veteran with a service-connected disability is eligible for health care services. Veterans with service-connected disabilities represented about 34 percent of the applicants who sought medical care from the VA in fiscal year 1982. The remainder of the VA patients were veterans aged 65 or older (about one-fourth of patients discharged from VA hospitals in 1981), veterans who were unable to pay for their medical care, former prisoners of war, and veterans who were exposed to Agent Orange in Vietnam. Other veterans are eligible on a space-available basis. Veterans’ Service Organizations A number of veterans’ service organizations play a significant role in the overall delivery of health care by the VA (106). In terms of size of membership, the major organizations are The American Legion, the Veterans of Foreign Wars, and the Disabled American Veterans. At the na- tional level, these groups lobby for services and Figure 4.—Organization Chart of the Veterans Admi istration (VA), May 1984 aThis chart shows the relationships among the parts of the VA discussed in this chapter. bACMD = Assistant Chief Medical Director. CVA supply services are located in individual VA medical centers. dThe Prosthetic Technology Evaluation Committee advises the Prosthetics and Sensory Aids Service. SOURCE: Office of Technology Assessment. 6GL o $801A8(Q [BOIPBN Buipiebay $810110d UOHBIISIUIWPY SUBISIBA—/ "YO 160 » Federal Policies and the Medical Devices Industry attempt to influence legislative decisionmaking. At the local level, they are involved in a variety of activities including substantial support for com- munity programs. Because of their high visibil- ity in the community, local chapters of these orga- RESEARCH AND DEVELOPMENT The goals and priorities of the VA's R&D pro- gram are diverse, with broad mandates to address the very complex and difficult problems of vet- erans. The official role of the Federal Government in the R&D of medical devices, especially pros- thetic and disability-related research, dates back to the 1930s and 1940s. Since 1947, the VA has spent over $25 million on prosthetic device re- search alone (225). Research indicates that the Federal Government can be particularly effective in sponsoring R&D if the Government is itself the buyer of the re- sulting technologies (228). The VA spent well over $1 billion on all supplies and equipment for its various medical facilities in 1983. Especially in the area of rehabilitative devices, not only is the VA the major buyer in the country, but its R&D ef- forts are very important because of the small and fragmented nature of the market for many reha- bilitative technologies. Table 38 shows the VA budget for R&D activ- ities, as divided among the VA's three major R&D services: the Medical Research, the Rehabilitation Research and Development, and the Health Serv- ices Research and Development Services. Although funds committed to these R&D services by the VA in current dollars have increased over the past few years, the budgets of these services have been nizations can have an important influence on VA hospital activities. Hospital administrators are sensitive to their inquiries and complaints and usu- ally try to consult these organizations when ma- jor planning decisions are under consideration. stable or declining if inflation is taken into ac- count. Furthermore, total R&D as a proportion of medical care expenditures by the VA has been steadily declining for a decade. In fiscal year 1970, R&D budgets accounted for 3.4 percent of the outlay for the medical care program, compared with only 2 percent in fiscal year 1982 (433). Veterans’ service organizations have expressed concern about effective cutbacks in R&D budgets, especially in the areas of prosthetics research and research on sensory aids for blind and hearing- impaired veterans. The organizations argue that these research areas have received decidedly less funding than they merit (344). The bulk of R&D funds goes to the Medical Re- search Service, which provides opportunities for clinician and nonclinician scientists to study health problems in the veteran population. The empha- sis of the medical research is on clinical research, most of which is initiated by physician investi- gators who carry out their research part-time and spend the majority of their time treating veteran patients. Current studies involve cardiovascular, respiratory, and renal devices. A number of re- search projects are also conducted cooperatively, with clinical trials at multiple sites within the VA medical care system. The largest number of co- operative studies have tested drug therapies, fol- Table 38.—Veterans Administration (VA) R&D Budget Overview, Fiscal Years 1977-83 (thousands of dollars) Fiscal year 1977 1978 1979 1980 1981 1982 1983 Medical Research Service ........... $101,567 $108,153 $118,016 $122,745 $129,943 $130,842 $141,052 Staffing. ......coviii 4,220 4,367 4,217 4,171 4,171 3,845 4,015 Rehabilitation R&D Service. .......... 4,419 5,502 7,191 8,085 8,784 7,185 10,001 Staffing... 69 90 112 143 -143 128 250 Health Services R&D Service ......... 3,604 2,996 3,004 3,153 3,083 2,828 3,786 Staffing... 45 90 105 104 104 93 120 Total o.oo $113,924 $121,198 $132,645 $138,401 $145,942 $144,921 $159,224 SOURCE: U.S. Veterans Administration, 1983. Ch. 7— Veterans Administration Policies Regarding Medical Devices ® 161 lowed by surgical procedures, such as coronary artery bypass surgery (342). The Health Services Research and Development Service, which was organized in 1976, develops and supports programs designed to improve clin- ical and administrative decisionmaking in the VA medical care system. Its only research priority area that concerns medical devices is the assess- ment of the cost effectiveness of patient care tech- nologies. The third VA service, the Rehabilitation R&D Service, is substantially involved with re- search and medical devices, as described in the following section. Rehabilitation Research and Development Service The Rehabilitation R&D Service is the result of an increased focus, both at the VA and at the na- tional level, on rehabilitation research and engi- neering needs. In 1973, this program was sepa- rated from other R&D efforts at the VA and given a mandate to improve the quality of life and to facilitate greater independence for physically disabled veterans. The Rehabilitation R&D Service undertakes re- search, development, and evaluation of new re- habilitative devices and techniques. The main goal of the program, which is primarily oriented to so- phisticated equipment, is to develop “usable” devices that assist individuals. All activities are coordinated with the National Institute of Handi- capped Research at the Department of Education. The Rehabilitation R&D Service is also concerned with technology transfer, including increasing the availability of new devices on the market (352). The activities of the Rehabilitation R&D Serv- ice are concentrated in three areas—prosthetics, spinal cord injuries, and sensory aids, represent- ing the most prevalent service-connected disabil- ities of veterans. Prosthetics research makes up about 40 percent of the Rehabilitation R&D Serv- ice budget; research relating to spinal cord in- juries, with an emphasis on improving wheel- chairs, makes up about 30 percent of the budget; and research on sensory aids, which include aids for visually and hearing-impaired people and for communication disorders, makes up the remain- ing 30 percent (426). Research priorities within these areas are identified through a combination of internal review and workshops and seminars, which include representatives from provider and research groups, manufacturers, and disabled veterans’ organizations. The Rehabilitation R&D Service supports both intramural and extramural R&D programs, al- though over the past few years, funding has shifted away from extramural projects and toward in- tramural projects such as VA-established centers and their university-affiliated programs. Two rehabilitation R&D centers, tied directly to the VA Rehabilitation R&D Service, have recently been established: one in the Palo Alto VA Medical Cen- ter in California and the other in the Hines VA Medical Center in Illinois outside of Chicago. Six more such centers are planned by 1986. The rehabilitation R&D centers are affiliated with leading engineering schools in the same way that the VA medical centers are affiliated with medical schools. These affiliations bring faculty and students into clinical research settings to study the problems of disabled people and to investigate new procedures and devices to alleviate their problems. The rehabilitation R&D centers’ pri- mary goal is to apply advanced technology, such as microprocessors, to assist physically handi- capped veterans. In an approach similar to the rehabilitation R&D center concept, the Rehabilitation R&D Service is establishing university-affiliated research engineering programs to help support qualified engineering graduate students and faculty who undertake rehabilitation engineering projects. The thrust of the program is to interest engineering students in rehabilitation engineering and to create a flow of ideas and information between academia and the VA (69,125). VA Prosthetics Center? The VA Prosthetics Center is a VA R&D cen- ter in New York City that is within the Prosthetic 3Since its inception in 1956, the VA Prosthetics Center has also been known as the VA Rehabilitation Engineering Center (VAREC) and as the Prosthetic Evaluation Testing and Information Center (PETIC). 162 » Federal Policies and the Medical Devices Industry and Sensory Aids Service (see fig. 4). The VA Prosthetics Center was established in 1956 to con- duct R&D in rehabilitation engineering, to evalu- ate and test commercially available rehabilitative devices, to provide direct patient care for diffi- cult prosthetic and orthotic cases, and to manu- facture orthopedic footwear and prosthetic/or- thotic devices. In its earlier years, the VA Prosthetics Center was the “flagship” of a successful VA intramural research program in prosthetics and orthotics. The majority of the prosthetic limbs and the fitting techniques used today, for example, were devel- oped by the VA Prosthetics Center in the 1950s (431). However, a 1983 audit report by the VA's Office of Inspector General found management and operating problems at the VA Prosthetics Center, then known as the VA Rehabilitation Engineering Center (VAREC) (426). The report recommended changes in VAREC's organization, including discontinuation of the R&D program. TESTING AND EVALUATION Literally thousands of disability-related devices are being produced by the public, private, and nonprofit sectors. Although many are relatively simple and low-cost items, others are expensive and complex. Regardless of the devices’ cost, use, or complexity, certain criteria need to be met before these products enter widespread use. Safety and effectiveness, including durability and recom- mended applications, are the essential criteria that need to be evaluated (412). Currently, the responsibility for testing and evaluating medical devices is divided among sev- eral VA organizational units. Prototype rehabil- itative devices that are still in the developmental stage are evaluated by the Rehabilitation R&D Service. Once medical devices are commercially available, the responsibility for evaluation is split between: 1) the Prosthetic and Sensory Aids Serv- ice, which evaluates rehabilitative devices; and 2) the Office of Procurement and Supply, which evaluates all nonrehabilitative devices, equipment, and systems purchased by the VA. The VA's Department of Medicine and Surgery accepted the Inspector General's recommendation, disbanded the VAREC Research and Development Service in fiscal year 1984, and changed the orga- nization’s name to the Prosthetic Evaluation Test- ing and Information Center (PETIC) (430). The VA Prosthetics Center encouraged innova- tion in the past by demonstrating that new types of wheelchairs were technologically possible and safe, and, most importantly, that there was a substantial market for them—the VA (282). The Prosthetics Center's work with power wheelchairs in the early 1970s demonstrated that electric wheelchairs could be used safely at speeds greater than a slow walk and that they could be designed to be used on rough terrain. This situation en- couraged wheelchair manufacturers to begin mak- ing chairs with those capabilities. Efforts centered around lightweight sports wheelchairs had a simi- lar effect on manufacturers. Prototype Rehabilitative Devices Rehabilitative devices developed by the VA often do not complete the transition from research prototypes to commercially viable products. The VA's research funds have supported a number of expensive prototypes that have been neither put into general use for the veteran population nor discarded outright. Examples include a wheelchair with special electronic controls adapted for use in a vehicle, a four-bar linkage knee for use in above-knee prostheses, and a standing device for paraplegics (433). Although there are several reasons for the fail- ure of such prototypes to become viable products, one obstacle is the lack of unbiased evaluations of the prototypes that provide data on perform- ance and clinical applications. The inadequacy of internal testing and evaluation for prototype rehabilitative devices has been generally recog- nized by the VA. Although some VA facilities, including the rehabilitation R&D centers, the VA Prosthetics Center, and individual VA medical Ch. 7—Veterans Administration Policies Regarding Medical Devices e 163 centers, have been involved in testing new and emerging devices through various VA services, the Rehabilitation R&D budget has not provided adequate funds to purchase expensive prototypes for clinical evaluation (433). Moreover, the VA has had a general procurement policy of not pur- chasing equipment unless it is commercially avail- able and in clinical use (344). There have also been concerns about unneces- sary duplication in rehabilitative device evalua- tion when the Rehabilitation R&D Service has conducted testing. For example, special recrea- tional ski equipment for disabled people, which was developed and tested at the Palo Alto Reha- bilitation R&D Center and then further tested at four independent centers, could not be purchased for veterans until the equipment had gone through an essentially duplicative testing process at the VA Prosthetics Center (19,196). In response to these criticisms, the Rehabilita- tion R&D Service has recently established the Rehabilitation Research and Development Evalua- tion Unit, a coordinating group to conduct clini- cal evaluations of new devices, techniques, and concepts in rehabilitation and to promote com- mercialization of the prototype devices that are evaluated by the program. The new unit will be responsible for developing evaluation protocols and will generally oversee and coordinate the evaluation process. However, all the organiza- tional units within the VA that have a stake in the devices’ development and ultimate commer- cial success will share in funding the major evalua- tions (435). Although it is premature to assess the Rehabil- itation R&D Evaluation Unit at this time, the unit appears to have the potential of coordinating work so that evaluations are perceived as valid by organizational units of the VA that use the re- sults and duplication of effort is avoided. In an attempt to further structure its technol- ogy transfer efforts, the Rehabilitation R&D Serv- ice has recently entered into an interagency agree- ment with the U.S. Department of Commerce to identify and develop potential markets and financ- ing for prototype devices that were funded and developed by projects of the Rehabilitation R&D Service. The goal of the interagency program is to develop a process that leads to the commer- cialization of VA devices and technology. Commercially Available Rehabilitative Devices Once rehabilitative devices are commercially available, the responsibility for their evaluation shifts from the Rehabilitation R&D Service to the VA's primary user service, the Prosthetic and Sen- sory Aids Service. Throughout the 1970s, the Prosthetic and Sensory Aids Service increasingly employed performance standards in its prosthetic and sensory aids program. These standards are developed with the participation of individuals and organizations both within and outside the VA. Manufacturers, professionals, VA supply specialists, and others review the standards, which provide product specifications to control devices’ quality, safety, and performance. After a performance standard for a rehabil- itative device has been established, the VA Pros- thetics Center tests the device for compliance with the standard and determines whether or not prod- ucts meet the VA's requirements. As noted earlier, the VA Prosthetics Center has recently become the VA's organizational focus for evaluation of commercially available rehabilitative devices. The testing protocols used by the VA Pros- thetics Center range from simple validation assess- ments to complex clinical evaluations involving dozens of VA medical centers or clinics. At the least, rehabilitative devices are tested for safety, reliability, and the validity of manufacturers’ claims. Devices can undergo either special laboratory testing or “field testing” at VA medical centers. Field testing, although advantageous in that it assesses devices’ “usefulness,” has never been uti- lized extensively by the VA Prosthetics Center be- cause of organizational difficulties. Until fiscal year 1984, no line authority existed from the VA Prosthetics Center staff or from the Prosthetic and Sensory Aids Service to the medical centers. The absence of line authority has typically resulted in loss of control over adherence to protocols and lack of reliable reporting of evaluation data (465). 164 e Federal Policies and the Medical Devices Industry The VA evaluation process for commercially available rehabilitative devices has increasingly been the target of complaints, particularly from veterans’ groups. The Disabled American Vet- erans has characterized the evaluation system as being “fraught with inefficiencies and communi- cation breakdowns” (439). There has also been criticism on several other fronts: that testing priorities are not adequately established; that long lags exist in the evaluation process; that the needs of veterans for devices should be better antici- pated; that the devices should be evaluated for safety by the Food and Drug Administration in- stead of by the VA; and that the VA should test for efficacy and cost effectiveness. The standard-setting process has also been a cause of concern for veterans’ organizations and others. Critics claim that the VA specifications have often been written to the specifications of a particular manufacturer's product, putting other manufacturers at a distinct disadvantage in the VA market. If such specifications define the di- mensions and materials to be used in devices, it is more difficult for emerging devices that are dif- ferent in design or performance levels to enter the general marketplace (352). Shepard and Karon, who studied the VA's ef- fects on the wheelchair industry, concluded that the large population of users in the VA could af- ford an opportunity for the VA to expand its role in postmarketing surveillance of wheelchairs (252). Such surveillance could yield better data on the frequency of repairs and the advantages and dis- advantages of particular models during actual use. VA standards in the past had apparently been tied to the design of a particular wheelchair (manu- factured by Everest and Jennings) rather than based on performance. The need for performance- based standards in the future has been recognized, and the VA has taken steps to produce such stand- ards. VA standards are important to the indus- try, as evidenced by responses to Shepard and Karon's telephone survey. One manufacturer stated that it hesitates to make anything that it cannot sell to the VA; other manufacturers stated that VA standards are considered when they make R&D decisions (282). The VA exercises its greatest market power in the “depot” wheelchair, an inexpensive general- purpose manual wheelchair. On the one hand, the VA's large purchases of this model reduce its price to the VA. On the other hand, the VA tends to discourage ordering of chairs with more user features or better technology. If alternative models were also stocked, price advantages could still be obtained (although possibly not so good as the present ones) and more desirable features, such as lighter weight, could be offered to disabled veterans (281). Over the past 2 to 3 years, the VA procurement process has replaced most standards and device specifications with more general purchase de- scriptions—commercial item descriptions (CIDs)— that are designed to accommodate the variety of privately developed and marketed devices (32). CIDs are simplified product descriptions that iden- tify by functional or performance characteristics the available, acceptable commercial products for Government use. Currently, the VA has standards for only four or five rehabilitative devices, though these stand- ards are applied to a wide range of devices. For example, the standard for wheelchair lift systems covers 21 different models and 13 different man- ufacturers. The increased use of CIDs, however, has also been criticized. A 1982 study by the U.S. General Accounting Office concluded that the CIDs contained too little specific information, with the result that the VA was purchasing many medical items that were either unnecessary or of lower quality (332). To address these concerns, the Prosthetic and Sensory Aids Service initiated the Prosthetic Tech- nology Evaluation Committee in 1982. This com- mittee has developed an evaluation and coordi- nation process for rehabilitative devices that will soon be operational in the VA system. The Prosthetic Technology Evaluation Com- mittee’s strengths lie in two areas. First, the com- mittee will coordinate evaluation activities with all the concerned participants inside the VA sys- tem, as well as with other Federal agencies, inde- pendent testing labs, and veterans’ organizations. Representatives from the VA's Prosthetic and Sen- sory Aids Service, Office of Procurement and Supply, Inspector General's Office, Rehabilitation R&D Service, Rehabilitation Medicine Service, Ch. 7— Veterans Administration Policies Regarding Medical Devices © 165 and from the Paralyzed Veterans of America and the Disabled American Veterans are permanent members of the Prosthetic Technology Evaluation Committee. Second, the committee will classify devices into three product levels according to po- tential level of risk, innovation, and cost, and the classification will determine the types of evalua- tions that the devices will undergo. ‘The Prosthetic Technology Evaluation Com- mittee has enlisted the support of important con- sumer groups such as the Paralyzed Veterans of America and The American Legion, and it appears to be taking the necessary steps toward a more coherent and well-focused program of evaluation (245,288). But the committee still has some prob- lems to resolve—such as expanding the VA Pros- thetics Center's field-testing activities, making evaluations more national in scope, and establish- ing the committee's authority over the evaluation activities of the VA medical centers. Commercially Available Equipment and Supplies At any given time, at least 250 nonrehabilitative devices, ranging from hospital-based equipment to supplies and disposables, are being reviewed by the VA's Office of Procurement and Supply as a prerequisite to procurement contracts. Its Testing and Evaluation Staff, which was estab- lished in 1976 and is part of a larger marketing center and supply depot in Hines, Illinois, has pri- mary responsibility for this aspect of the VA's de- vice-testing activities. The Testing and Evaluation Staff, with fewer than a half-dozen professionals, also has respon- sibility for a market research and analysis pro- gram. The staff identifies specific medical devices for evaluations through requests by VA medical centers, manufacturers, and the VA Central Of- fice, as well as through in-house initiatives. Fac- tors such as volume and interest expressed by VA health care facilities are usually more important than the cost of the products (238). Thus, evaluations of nonrehabilitative equip- ment and supplies are primarily carried out on standard stock items and smaller medical equip- ment. Very expensive equipment, such as com- puted tomography (CT) scanners, is not evaluated by the Testing and Evaluation Staff; the service directors in the VA's Central Office are responsi- ble for approving or disapproving the acquisition of such “controlled items.” These central purchase decisions are based on either test data generated by manufacturers, local medical equipment com- mittees in individual medical centers, or, in a few instances, interdisciplinary advisory committees convened by the Central Office. The Testing and Evaluation Staff's evaluations are usually internal “consumer research” efforts aimed at validating manufacturers’ claims about their products. VA regulations prohibit explicit comparison of one product with another. Al- though some evaluations of classes of devices have been attempted—evaluations that begin to move toward analyses of relative efficacy or cost-ef- fectiveness—staffing and budget constraints have restricted the number of these efforts (238). Typically, tests on individual devices are car- ried out at VA medical centers around the coun- try and take the form of user surveys. The results are synthesized into very short summaries and published quarterly by the VA Office of Procure- ment and Supply. The Testing and Evaluation Staff also manages a computerized information system with price and marketing data on medi- cal devices. The results of evaluations of nonrehabilitative equipment and supplies by the Testing and Evalua- tion Staff are well disseminated to users within the VA health care system. Although the Office of Procurement and Supply is sometimes reluc- tant to publish the test results because the par- ticular needs of veterans may be different from the needs of the general population, such infor- mation is routinely requested by non-VA hospi- tals, nursing homes, and State and local govern- ments. Manufacturers are not permitted to use the VA's evaluations in their own literature, but pri- vate publications such as Consumer Reports, Hos- pital Purchasing Management, and Health Devices Alert often reprint survey results (68,238,434). The Testing and Evaluation Staff's evaluations are advisory in nature. Although not scientifically rigorous, these evaluations do provide an infor- mation base for purchasing by individual VA fa- 166 ¢ Federal Policies and the Medical Devices Industry cilities. The Testing and Evaluation Staff's evalua- tions are, by all accounts, most often used by smaller, more rural VA facilities. The VA esti- PROCUREMENT AND SUPPLY The VA Office of Procurement and Supply is responsible for supplying the most extensive med- ical program in the Federal Government. In fiscal year 1982, the VA spent nearly $1.3 billion on supplies and equipment for its various medical fa- cilities. Totaling nearly 6,800 employees, the pro- curement and supply effort includes staff at the VA Marketing Center (VAMKC), the VA's Cen- tral Office, three supply depots, the Prosthetic Distribution Center, and 172 individual medical centers. Procurement staff have the twin goals of purchasing devices at the lowest possible cost and assuring the delivery of quality supplies and equipment for veterans. Efforts are divided be- tween central procurement activities and the local supply activities of the VA medical centers. Central Procurement by the VA Marketing Center VAMKC in Hines, Illinois, is the focus of the VA's national purchasing activity. That VAMKC has acted as the contract negotiator and admin- istrator for the U.S. Public Health Service, the armed services, and other Government agencies as well as for the VA has greatly enhanced its mar- ket leverage. In July 1983, VAMKC's shared pro- curement program with the Department of De- fense, for example, was awarding annual contracts of $295 million (428). Overall, VAMKC procurement accounts for a substantial, but not dominant, proportion of national demand for medical equipment and supplies. Bradburd found that VAMKC procurement accounted for 5 to 10 percent of the national sales volume in the mar- kets for X-ray, nuclear diagnostic, hemodialysis, and patient monitoring equipment (344). The market power of the VA allows it to ob- tain favorable prices on medical supplies through its centralized procurement channels (167). Vol- ume purchases of medical supplies and equipment are managed and distributed through three VA mates that only about 20 percent of its medical centers strictly adhere to purchasing decisions based on the evaluations. supply depots located in Somerville, New Jersey; Hines, Illinois; and Bell, California. The Prosthetic Distribution Center in Denver, Colorado, serves the approximately 200,000 veterans with serv- ice-connected disabilities. In fiscal year 1982, VA medical centers obtained about $198 million in supplies (about 15 percent of their total procure- ment needs) from the central supply depots (428). Several other centralized procurement programs provide individual medical centers with oppor- tunities to obtain economically priced supplies and equipment without having to solicit and award contracts. Under the Federal Supply Schedules program, the Government contracts with com- mercial vendors for a wide range of supplies and services at preestablished prices. VAMKC man- ages Federal Supply Schedules’ contracts for med- ical drugs, chemicals, supplies, and equipment, while the General Services Administration man- ages the contracts for most other items, such as furniture and office supplies (335). About 34 per- cent of total purchases by VA medical centers, or $434 million, were made through the Federal Supply Schedules program in fiscal year 1982 (428). Decentralized contracts are similar to the Fed- eral Supply Schedules program, in that medical centers order from VAMKC-administered con- tracts. Usually these contracts, which account for only about 3 percent of total purchases by medi- cal centers, are for specialized medical equipment that is unavailable through either the supply de- pot or Federal Supply Schedules programs. The impact of VAMKC's centralized procure- ment policies and procedures on product prices was studied by Bradburd specifically for this OTA report (42). The study examined VA procurement of nine categories of major medical equipment. Although the market was found to be highly con- centrated, the volatility of market shares and the Ch. 7—Veterans Administration Policies Regarding Medical Devices ¢ 167 very rapid pace of technological change suggested that the market was also extremely competitive. Bradburd’s findings with regard to six VAMKC procedures or policies are presented below (42). Brand Name Justification When a VA hospital receives authorization to purchase a particular item of equipment, VAMKC forwards to the hospital a list of the suppliers on contract whose equipment meets the requirements of the purchase order, ranked by order of cost. The hospital is required to purchase from the least- cost supplier unless it can justify purchasing from a different source based on service availability or another acceptable consideration. This exception process is called a brand name justification. Be- cause suppliers are anxious to maintain their share of the VAMKC market, the brand name justifica- tion requirement puts them under pressure not to price themselves out of the VAMKC market, and this concern almost certainly results in lower prices than would be obtained in the absence of this requirement. Firm Fixed-Price Clause Under the terms of a VAMKC contract, sup- pliers are not allowed to increase prices during the contract year. Furthermore, if they lower the price at any time during the year, the lower price holds for the balance of the contract year. The firm fixed-price clause may or may not result in lower procurement costs. During the course of the business year, there are times when suppliers of- fer temporary price discounts in the private mar- ket to promote their products. Normally, it would be expected that these promotions would be ex- tended to VAMKUC as well. However, because a temporary price cut must be extended for the en- tire contract year, suppliers are reluctant to offer such discount prices to VAMKC. Even the requirement that prices cannot be in- creased during the course of a contract year has indeterminate effects on procurement costs. On the one hand, such a requirement protects those who buy through VAMKC from price increases for the contract year. On the other hand, it is pos- sible that suppliers charge a higher price to begin with as a form of insurance against their margins’ being eroded by cost increases. It is not possible to determine the direction of the total impact of the firm fixed-price clause. Public Disclosure Requirements By law, the public has access to the prices at which VAMKC procures medical equipment. There is both theoretical and empirical support for the view that this results in higher procure- ment costs for VAMKC. The reasoning is that the benefits that a firm receives from cutting its price below that of its rivals are in part a function of the “retaliation lag,” the length of time before rivals learn of the price cut and cut their own prices in response. The price disclosure require- ments have the effect of reducing the retaliation lag, and therefore act to discourage such price cut- ting in the VAMKC market. In addition, because private buyers of medical equipment also have access to the price data, the fact that the VAMKC price may serve as the buyer's target in pricing negotiations can also in- hibit price cutting in the VAMKC market. Sup- pliers in the market for X-ray equipment, nuclear medical equipment, patient monitoring, and hemo- dialysis equipment indicate that prices offered to VAMKC are higher than they would be in the absence of the contract disclosure requirement. In markets where the disclosure requirement has not affected pricing, the perceived reason is that pricing information is widely available from other sources. No Volume Commitment VAMKC does not make specific volume com- mitments to its suppliers, who contract to pro- vide equipment at preestablished prices. In most equipment categories (other than X-ray and nu- clear diagnostic equipment), the absence of a vol- ume commitment is a major factor in supplier pricing behavior. There are several reasons why a volume com- mitment appears to be very important in some industries and unimportant in others. First, the importance of a volume commitment seems to de- pend on whether the equipment is typically “cus- tom made” or purchased from supplier stock. If equipment is purchased from stock and is fairly 168 Federal Policies and the Medical Devices Industry homogeneous, a volume commitment can provide reductions in manufacturing cost that can be passed on to the buyer in lower prices. Second, the importance of a volume commit- ment seems to depend on whether the equipment is expensive or inexpensive. If the equipment is inexpensive, the costs of preparing contracts and marketing the product to buyers are higher rela- tive to the purchase price of the equipment. In this situation, the cost savings that come with a volume commitment are more significant, and the commitment allows some of these savings to be passed on to the buyer. Some suppliers indicated a willingness to lower prices by 5 to 10 percent in exchange for a volume commitment. Even for relatively expensive devices, such as ultrasound equipment, one supplier stated that a group pur- chase of 15 to 20 units would suffice for a larger price discount than now offered. Most Favored Customer Clause Under the terms of a VAMKC contract, sup- pliers are not allowed to sell their equipment under a similar contract to any private buyer at a price lower than that offered to VAMKC. If a lower price is offered to a private buyer, the vendor must lower the VAMKC contract price to the same level for the balance of the contract. Because VAMKC must be offered a price as low as that offered to any private buyer, the most favored customer clause helps ensure that the VAMKC's clients benefit from competition among suppliers in the private hospital market. Although the strictness with which the most favored customer clause is interpreted varies from one equipment category to another, it almost cer- tainly has the effect of reducing VAMKC equip- ment procurement costs. The policy can also have a powerful impact on private buyers. In a few markets, private buyers are offered lower prices than VAMKC when they make contractual vol- ume commitments, on the grounds that the con- tracts are not like the VAMKC contract. In these markets, the impact of the most favored customer policy is obviously less than it is in other markets. “As noted above, VA suppliers may offer lower prices to private buyers if contract terms, such as volume commitments, differ. However, in many cases the most favored cus- tomer clause may have the effect of increasing prices that private buyers must pay for medical equipment. Specifically, both buyers in the VA and suppliers indicated that prices were affected in the markets for X-ray, nuclear diagnostic, ultrasonic, and patient monitoring equipment, as well as for CT scanning devices. Reluctance To Procure Mixed Systems Despite the absence of a formal restriction, VAMKUC has exhibited a reluctance to purchase medical equipment systems in which items of equipment produced by several different com- panies are interconnected. There are several rea- sons for this, the most important of which are the difficulties of assigning financial responsibility for repairs under warranty and of determining re- sponsibility for the actual interconnection of the equipment. Unfortunately, VAMKC'’s policy can have the effect of practically eliminating many smaller companies from the procurement proc- ess, and may, as a result, cause higher initial pro- curement costs for the VA. The reluctance to purchase mixed systems is based on actual pro- curement experience, but the practice merits peri- odic review to determine if it saves costs over time. Procurement by VA Medical Centers Actual purchase of medical equipment and sup- plies is carried out by local supply officers located in each of the VA medical centers. Although VAMKC is responsible for centrally managing and negotiating contracts for items commonly used by the medical facilities, individual VA med- ical centers make their own purchase decisions. To the extent that the medical centers use the cen- trally managed supply channels, lower product costs are available to them through the combined VA-wide quantity purchases. However, the VA hospital system is actually a loose confederation of semiautonomous institutions in terms of device procurement, thereby reducing many of the ad- vantages available to it as a large market power. Increasingly, the VA medical centers have pur- chased their supplies and equipment on the open market rather than using central supply channels. Ch. 7— Veterans Administration Policies Regarding Medical Devices © 169 Whereas in the early 1960s, only about 10 per- cent of their medical supplies were acquired through local-level open market purchases, in fis- cal year 1982, 39 percent of total purchases were made on the open market (131,428). Table 39 shows the relative contribution of each of the VA's supply channels to the total purchases made by the VA medical centers. The increase in open mar- ket purchases has resulted primarily from an im- plicit policy within the VA system to allow indi- vidual physicians the freedom to choose their own medical equipment and supplies. Both a 1980 General Accounting Office report (335) and the recent report by the President's Pri- vate Sector Survey on Cost Control (Grace Com- mission) (131) concluded that the VA was unnec- essarily paying more for supplies and equipment because of the large percentage of purchases be- ing made on the open market. Finding that the VA defeats the price advantages available to it through greater item standardization and volume purchases, the reports called for greater central purchasing through an expansion of national con- tracts. Table 39.—Veterans Administration Medical Center Purchasing Source Priorities, Fiscal Year 1982 Approximate Veterans annual Administration purchases Percentage Supply channel priority ranking ($ in millions) of total Veterans Administration excess ......... 1 NA NA Veterans Administration supply depots . .. 2 $197.9 15.3% Other Government excess -...«.«.-... 3 04 — Federal prisons and correctional institutions, blind-made and severely handicapped products . . .............. 4 1.0 1 General Services Administration stock LL... 5 34.1 2.7 Veterans Administration decentralized contracts .......... coi... 6 41.4 3.2 Federal Supply Service contracts . ........ 7 434.4 33.6 Open market purchases ................ 8 498.2 38.5 Other ...... none 86.0 6.6 NA indicates information not available. SOURCE: U.S. Veterans Administration, 1983. ADOPTION AND USE Rehabilitative Devices Unlike coverage policies under Medicare and Medicaid (see ch. 3), the VA's policy is to make available all rehabilitative technologies and de- vices that are suited to the needs of millions of eligible veterans. Of course, determinations about circumstances and clinical needs still need to be made, but VA policy is to provide blind veterans with the necessary services and devices to over- come their disability and to provide disabled veterans with all technologies and devices deemed medically necessary. An issue of mounting con- cern to the VA users and policymakers is the cost of this policy of covering all available technol- ogies and devices (352). 25-406 0 - 84 - 12 The range of rehabilitative medical devices pro- vided by the VA health care system is enormous. There are, for example, over 300 types of sensory aids provided for blind people (39). In fiscal year 1982, about 34,000 hearing aids and over $80 mil- lion in prosthetic services were made available to eligible veterans (426). In the area of rehabilita- tion services, more than 80 percent of eligible veterans have non-service-connected disabilities, with a large proportion suffering from the effects of chronic diseases associated with aging. Determinations of individual veterans’ needs are made at the clinical level, within the patient- physician relationship. Usually, the health pro- fessional caring for the patient requests procure- 170 » Federal Policies and the Medical Devices Industry ment of needed medical devices through the VA Supply Service in an individual VA medical cen- ter. However, procurement of prosthetic devices is handled differently. All prostheses, from eye- glasses to motorized wheelchairs, are obtained through the prosthetic representative, a veteran with a service-connected disability hired by the VA to serve as the purchasing agent. Clinical teams of physicians, physical/occupa- tional therapists, prosthetists, and prosthetic rep- resentatives meet with the veteran to decide which Photo credit: Amigo Sales, Inc. This woman is using an Amigo power wheelchair. For the provision of power, as opposed to manually operated, wheelchairs to veterans, the VA requires the approval of an individual VA medical center. prostheses should be prescribed. They then choose from among the possible range of devices that have been approved by the Prosthetic and Sen- sory Aids Service. Because of the relatively high volume of devices handled by the Prosthetic and Sensory Aids Serv- ice, the other VA rehabilitative services, such as the Spinal Cord Injury Service, have come over the years to use that service as a central purchas- ing clearinghouse for their own supplies and de- vices. This situation has involved the Prosthetic and Sensory Aids Service in ordering devices such as pacemakers that have very little to do with the actual functions of the prosthetic representatives. Although this manner of handling supply procure- ment has helped hold down the personnel require- ments of the other services, it has also placed in- creased fiscal and administrative burdens on the Prosthetic and Sensory Aids Service (93,439). The budget of the Prosthetic and Sensory Aids Service has tripled in 8 years to $84 million, and it has been projected to reach $500 million an- nually in 4 to 5 years (93). One of the major rea- sons for the steep rise in costs has been the in- creasing purchase of the sophisticated technology that is now available for use by disabled veterans. Another reason has been the growing population of veterans whose mobility and senses are affected by the aging process (426). Probably the most im- portant reason for the budget increases, however, is that, by law, the provision of prosthetics to veterans is unlimited. The growth in these costs has in turn taken resources from other parts of VA health care. Influence of Social, Political, and Economic Factors Political and social forces greatly influence the adoption and use of medical devices within the VA health care system. As mentioned earlier, for example, veterans’ service organizations frequently approach their local VA hospital administrators about buying the latest technologies for their vet- eran constituencies. As another example, Thomp- son has argued that decisions about VA hospital construction depend more on access to medical school skills and resources than on other concerns, Ch. 7—Veterans Administration Policies Regarding Medical Devices * 171 such as promoting access of veterans to medical care (298). The VA medical centers have tried to make their institutions hospitable places for teaching and research. In this regard, medical schools have often successfully encouraged VA hospitals to seek the latest in equipment and specialized facilities. A study by the National Academy of Sciences noted marked proliferation of special care units in VA hospitals by the end of the 1970s (224). Health planning and utilization review agen- cies (see ch. 6) have no authority over VA medi- cal centers. The National Health Planning and Resources Development Act of 1974 (Public Law 93-641) gave the VA voting membership on State health coordinating councils and on local health systems agencies, but VA medical centers submit applications for new construction or equipment to the local health planning agencies on a strictly voluntary basis. Likewise, the VA has successfully resisted efforts to place its hospitals under the authority of utilization and quality control peer review organizations, which perform utilization reviews for the Medicare and Medicaid programs. Instead, the VA moved to establish its own Health Services Review Organization to foster quality assessment and utilization review. Political and economic forces have acted to con- strain the adoption and use of medical devices. The VA's overall health care budget has been stable during the past few years, and the tight budget has undoubtedly served as the most pow- erful rein on overadoption. In addition, the con- gressional appropriations committees and other oversight groups have frequently opposed the VA's autonomy in decisionmaking with regard to resource allocation. In 1978, for example, efforts by the VA to supplement 24 existing CT scanners with 13 additional scanners were criticized by the General Accounting Office, and congressional re- sistance eventually prompted the VA to withdraw the request (330). As another example, the Of- fice of Management and Budget successfully pres- sured the VA to reduce its supply of hospital beds from roughly 121,000 in 1964 to fewer than 90,000 by 1980 (298). Overall, the concurrent social and political pressures that develop incentives to overadopt devices in some areas, while constraining expend- itures in others, have had important implications over time. The often sporadic patterns of adop- tion and use of devices and other technologies and patterns of care by the VA have led to a distribu- tion of resources that may not be equitable or ef- ficient across geographic areas or types of facil- ities. Thus, for example, although the VA is an international leader in such areas as cardiac care and radioisotopes, fewer than one-third of the VA medical centers had CT scanners in 1983 (150). In fact, an extensive study by the National Acad- emy of Sciences in 1977 found ample evidence of maldistribution in terms of equipment, basic and specialized services, staffing, and number of beds (224). Strategic Planning There is every indication that with regard to medical device and technology acquisition, the VA is in transition. Perhaps the most significant initiative undertaken by the agency in relation to medical equipment adoption and use has been the implementation since fiscal year 1981 of Medical District Initiated Program Planning (MEDIPP). The MEDIPP process is an attempt to create a de- centralized long-range “strategic planning system” in which major plan development responsibilities are assigned to the VA's 28 medical districts. The VA has recognized that past resource-based planning and management approaches are no longer feasible in an era of stable or declining health care budgets and changing demands by its aging veteran population. Although there will be increased demand for services in the short term as the size of the elderly veteran population grows, in the long-term, demand for services will decline as this largest group of beneficiaries now enter- ing old age dies. Because the future certainly holds cutbacks or termination of specific services or facilities, un- derstanding and acceptance within the VA and its constituencies are important factors in the even- tual success and implementation of the MEDIPP process. A key element of the new planning proc- ess is its emphasis on involving administrative and clinical personnel at several levels within the VA Department of Medicine and Surgery (429). 172 Federal Policies and the Medical Devices Industry The MEDIPP process consists of a cycle of events throughout the fiscal year. It begins with direction by the VA's Chief Medical Director on broad-based issues, objectives, and goals for the future. Each VA medical district then appoints a District Planning Board and staff to develop a district plan within the overall framework of systemwide goals. The district plans include a demographic analysis, a workload forecast, and a review of the local resources that are submitted by the VA health care facilities within its juris- diction. Finally, the district administrators and councils review and approve the district plans and submit them to the VA Central Office (218, 426,432). The first MEDIPP cycle ended in November 1982 and covers fiscal years 1985 to 1990. An in- ternal VA study examined the relationship be- tween technology needs and the MEDIPP plans that were submitted (45). It found that most of the medical districts were using the MEDIPP proc- ess to request the purchase of specific major med- ical devices and equipment, in addition to pro- posals for the creation, expansion, or dismantling of services. In effect, the MEDIPP process could serve as a vehicle for identifying and monitoring the need and demand for various types of major medical equipment. The study also found that VA administrators and planners ranked the issue of device acquisition (and the larger issue of medi- cal technology) fourth in importance among 50 VA-wide issue areas. These findings confirm and reinforce the po- tential utility of the MEDIPP process, not only as a planning tool, but also as an early warning and tracking system for major equipment adop- tion and use. As new device and equipment re- quests begin to surface through medical district plans, a coherent and well-focused program of evaluation could be initiated (45). Such evalua- tions could include broader technology assessment issues such as devices’ cost effectiveness in the overall delivery of care. Another new process that may affect medical device adoption and use is setting the budgets of VA medical centers on the basis of diagnosis related groups (DRGs) (103). Although the VA has budgeted prospectively because of the con- gressional appropriations process, the use of a case-mix measure such as DRGs is intended to dis- tribute the available funds more rationally among the medical centers. DRGs classify patients according to principal diagnosis, presence of a surgical procedure, age, presence or absence of significant comorbidities or complications, and other relevant criteria. The new Medicare prospective payment system for hospitals is also based on DRGs (see ch. 3). Both the VA budgeting system and the Medicare pay- ment system use similar mathematical models to assign patients to DRGs and to allocate resources among DRGs. Data sources included all VA discharge ab- stracts, costs across different service categories (medical, surgical, psychiatric), the current 470 DRG model, ® and the New Jersey Reimbursement Schedule. Since the VA has no patient-based method of assigning costs, the VA used New Jersey cost data to assign relative DRG weights to the VA discharges, and these weights were used for allocation decisions (104). The VA expects the new budget method to en- courage more efficient use of resources within hos- pitals and to distribute the funds more rationally because hospitals will receive funds on the basis of case mix instead of historical budgets. DRGs are also to be used in VA utilization review and quality assurance programs (104). Adoption of medical devices will be more affected by MEDIPP, although DRG budgeting will probably affect use of the devices. *There are 467 DRGs, plus 3 that require special treatment of the data: DRG 468 flags an operating room procedure that is unrelated to the principal diagnosis; DRG 469 represents a patient with a diag- nosis that is valid as a principal diagnosis, but not acceptable as a principal diagnosis; and DRG 470 indicates invalid data. Ch. 7—Veterans Administration Policies Regarding Medical Devices ¢ 173 DISCUSSION AND POLICY OPTIONS The VA has the potential to use its extensive procurement to influence the type and price of medical devices that are developed and marketed. Although the VA appears to have obtained lower prices because of purchases from least-cost sup- pliers, other procedures such as more standard- ized purchases and volume commitments to de- vice suppliers might result in greater price reduc- tions. In addition, R&D evaluation, and procure- ment have been separate, unintegrated activities within the VA. The potential of the VA's leverage has not been realized in stimulating the develop- ment of certain types of devices. Nor have the results of the VA's own R&D and evaluation activities been systematically incorporated into the VA's procurement and adoption decisions. In an attempt to coordinate these activities, the VA is discussing an administrative reorganization that would put the Rehabilitation R&D Service, ~ the Prosthetic and Sensory Aids Service, and the VA Prosthetics Center in one line (39). The fol- lowing sections offer options for specific improve- ments within the areas of R&D, testing and eval- uation, procurement, and adoption and use of medical devices by the VA health care system. Research and Development To give increased focus to its rehabilitation re- search efforts, the VA in 1973 organized the Re- habilitation R&D Service. More recently, the VA has established rehabilitation R&D centers that are affiliated with engineering schools (two at present, six more planned by 1986) for broader outreach. However, when inflation is taken into account, the VA's funding commitment to R&D has been stable or declining. Veterans’ service organizations have expressed concern about ef- fective cutbacks in R&D budgets, especially in the areas of prosthetics research and research on sen- sory aids for the blind and hearing-impaired. Option 1: Increase the VA's funding for reha- bilitative research that is focused on longer term development of devices. The appropriate placement of rehabilitation R&D of this type could be at the rehabilitation R&D centers, at the VA Prosthetics Center, or at both, depending on the goals of the Rehabilita- tion R&D Service. The rehabilitation R&D centers at Hines and Palo Alto are connected with their local engineering communities. The primary mis- sion of these centers is to apply advanced tech- nology to assist physically handicapped veterans with the goal of commercialization of the devices. The VA Prosthetics Center combines the devel- opment of commercially available prosthetics and sensory aids with clinical activities through an in- tegrated management. Its engineers and profes- sional personnel work closely with patients in sev- eral VA medical centers, customizing prosthetics and generally applying the expertise of the re- search engineers to present problems. In addition, within a fixed budget, any decision to channel more funds to long-term rehabilitative research would require a determination that such research was more worthwhile than other uses of these funds. Testing and Evaluation The responsibility for testing and evaluating medical devices is divided among several VA organizational units. The Rehabilitation R&D Service evaluates rehabilitative prototype devices that are still in the developmental stage. Once the medical devices are commercially available, the responsibility for evaluation is split between the Prosthetic and Sensory Aids Service for reha- bilitative devices and the Office of Procurement and Supply for all nonrehabilitative devices, equip- ment, and systems purchased by the VA. The Disabled American Veterans organization has called the evaluation system fraught with ineffi- ciencies and communication breakdowns. Efforts of the various organizational units have some- times overlapped and unnecessarily duplicated each other. The absence of internal planning and coordi- nation for its evaluation activities has generally been recognized by the VA. Recently, the Reha- bilitation R&D Service created the Rehabilitation R&D Evaluation Unit to coordinate and improve testing of prototype rehabilitative devices, and the Prosthetic and Sensory Aids Service formed the 174 » Federal Policies and the Medical Devices Industry Prosthetic Technology Evaluation Committee to develop a formal evaluation and coordination process for commercially available rehabilitative products. The Office of Procurement and Supply established the Testing and Evaluation Staff in 1976 to provide evaluations of nonrehabilitative medical devices, equipment, and supplies. The evaluations are incorporated into national pro- curement contract requirements, but are advisory only. Purchasing decisions still rest with individ- ual hospitals. These improvements in evaluation processes may result in more appropriate adoption and use of medical technologies by the VA. They may also result in better adoption and use of medical tech- nologies by other Government agencies and by the private sector through the dissemination of evaluation findings. Although it is premature to assess these newly created committees and pro- grams, options for specific improvements are pre- sented below. Option 2: Encourage the expansion of field testing of rehabilitative devices by the VA Prosthetics Center. The VA Prosthetics Center is charged with per- forming “compliance testing” on all commercially available rehabilitative devices for the Prosthetic and Sensory Aids Service. Devices can undergo either special laboratory testing or field testing at VA medical centers, or both. Field testing is advantageous in that it allows an evaluation to more accurately assess a device's usefulness to the veteran population. Because of organizational difficulties, however, the VA Pros- thetics Center has never used field testing to its fullest possible extent. Until fiscal year 1984, there was no line author- ity from the VA Prosthetics Center or from the Prosthetic and Sensory Aids Service to the VA medical centers, where the field evaluations are performed. Absence of line authority had resulted in a loss of control by the testing units over adher- ence to protocols and reporting of evaluation data and often created initial resistance to cooperation in device studies. The new Prosthetic Technology Evaluation Committee, which includes representatives from all the concerned organizational units within the VA, is mandated to classify devices into groups which will determine the types of evaluations that the devices will undergo. This committee will need to establish some internal control over the VA medical facilities to assure adherence to evalua- tion protocols and the collection of accurate data during expanded field studies. Option 3: Require the VA to conduct more com- parative evaluations before purchasing com- mercially available devices. Evaluations of devices by the Testing and Evalua- tion Staff of the VA's Office of Procurement and Supply are usually internal “consumer research” efforts that take the form of user surveys. Al- though not scientifically rigorous, they do pro- vide an information base for purchasing by indi- vidual VA medical centers. The VA estimates that only about 20 percent of its medical centers strictly adhere to purchasing decisions based on these evaluations. However, results of the evaluations are also routinely requested by private hospitals, nursing homes, and State and local governments. Evaluative information would be improved if more comparative evaluations that identified the positive and negative consequences of purchase and use of particular products were undertaken. Product quality features—such as safety, dura- bility, and performance—could be more closely matched with cost considerations. More valid results would also result from evaluating larger samples. Although the VA currently prohibits explicit comparison of one product with another, the Testing and Evaluation Staff has attempted some group evaluations of classes of devices. The pri- mary obstacle to expanding these efforts has been staffing and budgetary constraints. These con- straints might have to be eased in order to pro- vide better evaluative information for VA pur- chasing decisions. Procurement Available evidence indicates that the VA's cen- tralized procurement programs, through various contract and distribution mechanisms, have for the most part created favorable prices for medi- Ch. 7—Veterans Administration Policies Regarding Medical Devices e 175 cal equipment and supplies for the VA medical centers. Some policies, like the most favored cus- tomer clause, almost certainly reduce the VA's equipment procurement costs, but at the same time have the effect of increasing the prices that private buyers must pay for medical equipment. At least one policy, the VA's refusal to provide volume commitments to contractors, probably results in the VA's not getting the lowest prices possible for some medical devices. Other policies are more ambiguous with respect to their impact on procurement costs. A greater problem for the VA is the extent to which the VA medical centers fail to use cen- tralized procurement channels. VA medical facil- ities now purchase about 39 percent of their sup- plies and equipment on the open market, up from 10 percent in the early 1960s. This individual pur- chasing reduces the advantages available to the VA as a large institutional buyer. Option 4: Encourage the VA to increase the pro- portion of its procurement of equipment and supplies by centralized contracts to realize lower costs from the VA's leverage in the mar- ketplace. Combining quantity purchases of equipment and supplies on a national basis through cen- tralized procurement could result in lower prod- uct costs through price discounts. Centralizing more device purchases could increase the VA's buying power and could lead to even greater price discounts. There are problems, however, in getting phy- sicians to support more centralized procurement. As part of the effort to retain physicians on staff, it has been the practice of the VA since the 1960s to allow physicians to choose their own brands of medical equipment and supplies. The difficulty of achieving physician/user acceptance of one spe- cific type of medical equipment is a substantial obstacle to increasing centralized procurement. Use of consensus groups might be one mecha- nism to help physicians reach agreement, or per- haps hospital administrators could be given greater authority. The extent of disagreement among phy- sicians regarding the desirability of particular brands or models of medical equipment varies depending on the type of equipment, the num- ber of manufacturers, and other less tangible factors. Adoption and Use Because of incentives to overadopt in some areas and concurrent financial constraints in others, the VA has experienced sporadic patterns of adop- tion and use of devices and other technologies that have led to a distribution of resources that may not be equitable or efficient across geographic areas or types of facilities. For example, some types of major medical equipment, such as CT scanners, may have been underadopted by the VA because of political pressures to contain costs. On the other hand, by statute, the provision of re- habilitative devices to veterans is unlimited. As a result, resources have been drained away from other parts of the VA's health care budget as costs for rehabilitative devices have expanded. Option 5: Encourage development of comprehen- sive evaluations of major medical equipment as part of the VA's strategic planning process. The VA lacks systematic methods for distrib- uting major new medical equipment among its medical centers and within its districts. The new MEDIPP (Medical District Initiated Program Planning) process is an attempt to create a decen- tralized long-range strategic planning process in which plan development responsibilities are as- signed to the VA's 28 medical districts. The MEDIPP process could serve as a vehicle for identifying and monitoring the need and demand for various types of major medical equipment. A coherent, focused evaluation program could then be initiated to guide the adoption and use of new medical equip- ment within the VA. In June 1983, the VA's Chief Medical Director formed a High-Technology Assessment Group to determine future VA policy on the acquisition of major new technologies. Comprehensive technol- ogy assessments have not as yet been used exten- sively in the VA health care system. The VA con- tinues to face the constraints of stable or declining health care budgets, and the use of analytical methods to evaluate the health and economic ef- fects of technologies could assist in developing in- 176 Federal Policies and the Medical Devices Industry formation for allocating health care resources useful information. But decisions about device more effectively and equitably than in the past. adoption and use would still require judgments The process of conducting such evaluations would about factors such as equity and ethics that are raise relevant issues and the results might provide difficult to incorporate into an analysis. Appendix A.—Method of the Study On June 17, 1982, OTA’s Technology Assessment Board approved the assessment entitled “Federal Pol- icies and the Medical Devices Industry,” to begin Sep- tember 1, 1982. The proposal stated that the study would address gaps in basic information about the medical devices industry and would examine present and proposed Federal policies that influence the sector. During the planning period that preceded the study, OTA staff consulted with industry trade associations, consumer groups, and Federal agencies for two pur- poses: to seek suggestions for members of the study's advisory panel and to identify issues in the field. An advisory panel guides OTA staff in selecting material and issues to consider and reviews written work, but the panel is not responsible for the content of the final report. The advisory panel selected for this assessment con- sisted of members from different segments of the industry—large and small companies, medicine, nurs- ing, hospital administration, economics, policy anal- ysis, law, and consumer advocacy. Richard R. Nelson of Yale University chaired the panel, and two other members, Joyce Lashof and Rosemary Stevens, served concurrently on the standing Health Program Advi- sory Committee. At the beginning of the study, the staff compiled a bibliography and gained familiarity with major issues and with sources of data on com- panies that make up the industry. This effort was aided by a background paper prepared by Anthony A. Romeo and by a September meeting with company ex- ecutives arranged by the Health Industry Manufac- turers Association. The study was also considered at the September meeting of the Health Program Advi- sory Committee, which advised that the perspectives of consumers and of different segments of the indus- try be sought. At the first panel meeting, on October 7, 1982, dis- cussion centered on the overall study plan and on ma- jor policy areas, especially payment for the use of med- ical devices and premarket regulation by the Food and Drug Administration (FDA). In order to illuminate cer- tain policies and to gain greater insight into certain segments of the industry, it was decided to select spe- cific medical devices for more detailed case study. The panel discussed criteria for selecting the case studies, including the importance of certain policies. Also raised was interest in the process by which devices are developed and brought to market. Following the panel meeting, OTA staff selected six case studies: the Boston elbow, contact lenses, hemo- dialysis equipment, nuclear magnetic resonance imag- ing, technologies for urinary incontinence, and wheel- chairs. It was also decided to produce a separate technical memorandum on the policies of the Veterans Administration (VA) concerning medical devices, since the relevant policies of this health care delivery sys- tem are both extensive and separate from others. The technical memorandum was to be prepared by OTA staff, and the case studies and other background papers by contractors outside of OTA. On the basis of advice from the Health Program Advisory Committee and the advisory panel for this assessment, two workshops were held at OTA in De- cember 1982: one on December 7 on the purchase and use of medical devices and the other on December 15 on research, development, and marketing of medical devices. Suggestions for organizations and individuals to participate were solicited from a wide range of in- terested parties. The first workshop, which was chaired by Louise Russell from the advisory panel, consisted of people involved in different facets of the purchase and use of devices, including multihospital organizations, muni- cipal hospital administration, hospital administration in the VA, hospital bioengineering, handicapped peo- ple, and physicians of different specialties (see app. B). Although their interests varied, the participants shared the need for better evaluative information on devices, concern about postmarketing surveillance of device problems and standard setting for devices by FDA, and interest in devices that meet a clinical need instead of overly sophisticated ones. The participants at the second workshop, chaired by Richard Nelson of the advisory panel, were in- volved in the invention, development, and marketing of devices as individual inventors, managers in large companies, university researchers, or marketing rep- resentatives (see app. B). Discussion in this workshop centered on problems in commercializing devices, espe- cially in securing funding to develop prototype devices; the role of Federal regulation, including FDA, VA, and the Patent Office; the role in the development process of different actors, such as individual inventors, small firms, and large firms. On the basis of this discussion, the OTA staff decided to compile vignettes on the de- velopment process from inventors of different devices and from different organizations. The staff next prepared a draft status report, which presented information gained up to that point in the study on the industry and on Federal policies regard- ing payment, FDA regulation, the VA, research and development, patents, and international trade. The status report was the major topic of the second panel meeting held at OTA on March 3, 1983. The discus- sion pointed out the advisability of focusing the final report of the assessment on policies specific to medi- 179 180 e Federal Policies and the Medical Devices Industry cal care and, within those policies, on matters related to medical devices. Considerable discussion at the panel meeting also surrounded FDA regulation of medical devices. Be- cause of the importance of this policy area, a work- shop on regulation under the 1976 Medical Device Amendments was held at OTA on May 19, 1983. Par- ticipants included attorneys and other policymakers from Federal agencies, consumer groups, and private firms who had been involved in drafting and imple- menting the legislation (see app. B). The workshop dis- cussed the intentions of the framers of the law, the evolution of the bill as it went through the legislative process, and its implementation as practical problems were faced by FDA. At its third meeting, on August 4, 1983, the advi- sory panel discussed the revised draft of the status re- port as well as drafts of a case study and background paper that had been received. The panel noted that the report would have to take into account the changes in payment occasioned by Medicare's forthcoming use of diagnosis related groups. The final draft of the status report was sent to the requesting congressional com- mittees in order to inform them of the progress and components of the study. During the fall and early winter, drafts of the re- maining case studies and background papers were re- ceived, sent to the advisory panel and other experts for review, and revised by contractors. The material was therefore available to OTA staff as they were pre- paring the first draft of the final report. In March 1984, that draft was sent to the advisory panel, the Health Program Advisory Committee, and 75 other reviewers who are experts in fields related to different aspects of the study. The draft report was discussed at the March 31 meeting of the Health Program Advisory Committee and at the fourth and final meeting of the advisory panel on April 3. The committee advised that more note be taken of devices for which adoption and use have been insufficient. The advisory panel concen- trated on the summary chapter, FDA regulation, and policy options. After the meeting, OTA staff revised the final report based on comments received from the panel and other reviewers and in early May sent the revised summary chapter to the advisory panel and the Health Program Advisory Committee. The revised report was reviewed within OTA and in mid-May was submitted for approval to the Technology Assessment Board. Several documents are being published in connec- tion with the assessment: the main report (of which this appendix is a part), a booklet summarizing the main report, a technical memorandum on policies of the VA, a background paper of inventors’ vignettes, and six case studies. In addition to this report and the summary, the following publications will be available through the U.S. Government Printing Office: e Inventors’ Vignettes of the Development of Med- ical Devices, edited by OTA staff. ® Medical Devices and the Veterans Administra- tion, by OTA staff. ® Technologies for Managing Urinary Incontinence, by Joseph Ouslander and Robert L. Kane, Univer- sity of California, Los Angeles. e The Boston Elbow, by Sandra J. Tanenbaum, Massachusetts Institute of Technology. e The Contact Lens Industry: Structure, Competi- tion and Public Policy, by Leonard G. Schifrin, College of William and Mary. ® Nuclear Magnetic Resonance Imaging Technol- ogy: A Clinical, Industrial, and Policy Analysis, by Earl P. Steinberg and Alan B. Cohen, Johns Hopkins Medical Institutions. ® The Hemodialysis Equipment and Disposables In- dustry, by Anthony A. Romeo, University of Connecticut. e The Market for Wheelchairs: Innovations and Federal Policy, by Donald S. Shepard and Sarita L. Karon, Harvard School of Public Health. In addition, papers were prepared on contract to OTA to provide background information for the main report and are available through OTA in limited quan- tities: e “Capital Markets, Government Regulation, Tax Policy, and the Financing of Medical Device In- novations,” by James R. Barth and Joseph J. Cordes, with Michael Bradley, George Washing- ton University. ® “Governmental Barriers to International Trade in Medical Devices in the United States, United Kingdom, France, the Federal Republic of Ger- many, Canada, Japan, and Mexico,” by Kaye, Scholer, Fierman, Hays & Handler, Washington, DC. ® “Innovative Activity in the Medical Devices In- dustry,” by Anthony A. Romeo, University of Connecticut. e “Medical Device Standards and International Trade,” by Kornmeier, McCarthy, Lepon & Harris, Washington, DC. ® “The Impact of Federal and State Regulatory Pro- grams on the Ambulatory Laboratory Testing In- dustry and the Demand for Instrumentation,” by Hope S. Foster, O'Connor & Hannan, Washing- ton, DC. e “The Relationship of FDA, PHS, and HCFA Regarding Medical Device and Organ Transplant App. A—Method of the Study ¢ 181 Technologies,” by Dennis J. Cotter, Georgetown netic Resonance (NMR) in the United Kingdom,” University. by John Hutton, University of York, England. e “The Role of the Government in the Research, De- e “Veterans Administration Procurement and the velopment, and Commercialization of Computed Market for Medical Equipment,” by Ralph M. Tomography (CT) Scanning and Nuclear Mag- Bradburd, Williams College. Appendix B.—Acknowledgments and Health Program Advisory Committee This report has benefited from the advice and review of several other people in addition to the advisory panel. The staff would like to express its appreciation to the following people for their valuable guidance. Emily Arakaki U.S. Department of Commerce Washington, DC Claude Bandy U.S. Department of Commerce Washington, DC Carl Blozan U.S. Food and Drug Administration Rockville, MD Robert Britain U.S. Food and Drug Administration Silver Spring, MD Gil Devey Washington, DC Fred Downs U.S. Veterans Administration Washington, DC Lily Engstrom National Institutes of Health Bethesda, MD Marion Finkel U.S. Food and Drug Administration Rockville, MD Richard Flaherty Health Industry Manufacturers Association Washington, DC Susan Foote University of California, Berkeley Berkeley, CA Ghislaine Francis U.S. Department of Commerce Washington, DC Margaret Gianinni U.S. Veterans Administration Washington, DC Jonathan Gold Office of Health Planning U.S. Public Health Service Rockville, MD 182 Warren Hyer Biomedical Network, Inc. Lawrenceville, NJ Michael Kenney Berkeley, CA Philip Marcus U.S. Department of Commerce Washington, DC Robert C. McCune National Electrical Manufacturers Association Washington, DC Robert S. Musitano Dun & Bradstreet Washington, DC Wayne Roe Health Industry Manufacturers Association Washington, DC Paul Ryser IMS America, Ltd. Rockville, MD William K. Scheirer U.S. Small Business Administration Washington, DC F. M. Scherer Swarthmore College Swarthmore, PA Al Schnupp U.S. General Accounting Office Rockville, MD William Starr U.S. Department of Commerce Washington, DC George Willingmyre Health Industry Manufacturers Association Washington, DC Dennis Wyant U.S. Veterans Administration Washington, DC App. B—Acknowledgments and Health Program Advisory Committee ¢ 183 Workshop on the Purchase and Use of Medical Devices, Dec. 7, 1982 Robert Berenson Washington, DC Frank Bowe Cedarhurst, NY Dennis Cotter Georgetown University Health Policy Center Washington, DC Danny Foutch Hospital Corp. of America Nashville, TN Pradeep Gupte Westchester County Medical Center Valhalla, NY Ralf Hotchkiss Oakland, CA Phyllis Leppert Columbia-Presbyterian Medical Center New York, NY John Matoole Veterans Administration Medical Center Omaha, NE James Mongan Truman Medical Center Kansas City, MO Louise Russell The Brookings Institution Washington, DC Kent Samuelson Salt Lake City, UT William Schneider Kaiser-Permanente Medical Care Program Oakland, CA Workshop on Research, Development, and Marketing of Medical Devices, Dec. 15, 1982 William Adams Surgilite International, Inc. Long Beach, CA Perry Blackshear, Jr. Massachusetts General Hospital Boston, MA Thomas Carney Metatech & Bioferm Northbrooke, IL Wilson Greatbatch Greatbatch Enterprises, Inc. Clarence, NY Richard Nelson Institute for Social and Policy Studies Yale University New Haven, CT William Partridge University of Utah Research Institute Salt Lake City, UT Richard Rettig Illinois Institute of Technology Chicago, IL Walter Robb Medical Systems Operations General Electric Co. Milwaukee, WI Aron Safir University of Connecticut Health Center Farmington, CT 184 e Federal Policies and the Medical Devices Industry Workshop on Standards, Aug. 17, 1983 Russell J. Arnsberger Becton Dickinson & Co. Washington, DC E. Ronald Atkinson American Hospital Supply Corp. Evanston, IL Robert Avrutik Philips Medical Systems, Inc. Shelton, CT Richard G. Flaherty Health Industry Manufacturers Association Washington, DC Robert C. Flink Medtronic, Inc. Minneapolis, MN Thomas E. Kimble DuPont Clinical & Instrument System Division Wilmington, DE Harold May Ohio Medical Products Madison, WI Thomas D. Nickel Travenol Laboratories, Inc. Deerfield, IL George T. Willingmyre Health Industry Manufacturers Association Washington, DC Henry Wishinsky Miles Laboratories, Inc. Elkhart, IN HEALTH PROGRAM ADVISORY COMMITTEE Sidney S. Lee, Committee Chair President, Milbank Memorial Fund New York, NY Stuart H. Altman* Dean Florence Heller School Brandeis University Waltham, MA H. David Banta Deputy Director Pan American Health Organization Washington, DC Carroll L. Estes** Chair Department of Social and Behavioral Sciences School of Nursing University of California, San Francisco San Francisco, CA Robert Evans Professor Department of Economics University of British Columbia Vancouver, BC Rashi Fein Professor Department of Social Medicine and Health Policy Harvard Medical School Boston, MA Harvey V. Fineberg Dean School of Public Health Harvard University Boston, MA Melvin A. Glasser*** Director Health Security Action Council- Committee for National Health Insurance Washington, DC Patricia King Professor Georgetown Law Center Washington, DC Joyce C. Lashof Dean School of Public Health University of California, Berkeley Berkeley, CA Alexander Leaf Professor of Medicine Harvard Medical School Massachusetts General Hospital Boston, MA App. B—Acknowledgments and Health Program Advisory Committee e 185 * Kk kk Margaret Mahoney President The Commonwealth Fund New York, NY Frederick Mosteller Professor and Chair Department of Health Policy and Management School of Public Health Harvard University Boston, MA Norton Nelson Professor Department of Environmental Medicine New York University Medical School New York, NY Robert Oseasohn Associate Dean University of Texas, San Antonio San Antonio, TX Nora Piore Senior Advisor The Commonwealth Fund New York, NY Mitchell Rabkin* President Beth Israel Hospital Boston, MA *Until April 1983. **Until March 1984. ***Until October 1983. ****Until August 1983. 25-406 0 - 84 - 13 Dorothy P. Rice Regents Lecturer Department of Social and Behavior Sciences School of Nursing University of California, San Francisco San Francisco, CA Richard K. Riegelman Associate Professor George Washington University School of Medicine Washington, DC Walter L. Robb Vice President and General Manager Medical Systems Operations General Electric Milwaukee, WI Frederick C. Robbins President Institute of Medicine Washington, DC Rosemary Stevens Professor Department of History and Sociology of Science University of Pennsylvania Philadelphia, PA Appendix C.—The Innovative Process in the Medical Devices Field Introduction As a society, we value technological progress—the continual “introduction to practice of new and more useful ways of serving human purposes” (262). In the health field, technological progress is often embodied in the introduction of new medical devices. Despite its importance, there has been little systematic inves- tigation of the process of technological change for med- ical devices. How and by whom do medical devices get developed? And what factors influence their de- velopment? There are, of course, many stories about the intro- duction of specific new devices, such as electronic fetal monitors (410), gastric freezing (114), gastroendo- scopes (448), and computed tomography (CT) scan- ners (348). These individual cases demonstrate the diversity of developmental pathways taken. They sug- gest that simple generalizations of the process are im- possible. Yet, some elements of the process may be common to all medical devices and, indeed, to all new technologies. The basic unit of technological change is innova- tion—a new device, product, or process introduced to practice for the first time (223,182). Innovation is also widely used to refer to the process by which techno- logical change occurs (232). In this OTA assessment, “innovation” refers to the newly introduced technol- ogy and “innovative process” to the process by which innovations find their way into practice. This appen- dix explores the process of technological change in gen- eral, with emphasis on the questions of who develops innovations and under what conditions the innovative process occurs. Innovations are valued for their capacity to increase productivity or the quality of consumption (274). Those innovations largely affecting production proc- esses have been called process innovations, while those intended for sale are product innovations (438). New medical devices are product innovations, although they may change the process of medical care. One important view of the innovative process is that it consists of four essential functions (274):! 1There are several other models of the “innovative process” that focus on the chronological stages rather than on critical functions. Schumpeter defined technical change as having three steps: invention, innovation, and imitation (or diffusion) (274). A recent study of the Organization for Economic Coop- eration and Development has identified four stages of innovation: concep- tion, reduction to practice (i.e., prototype), startup, and expansion (diffu- sion) (236). These alternative characterizations of the innovative process do not contradict one another; they highlight the points in the process of inter- - est to each author. 186 ® Invention—the act of insight by which a new and promising technical possibility is recognized and worked out (at least mentally and perhaps also physically). e Development—the sequence of detail-oriented technical activities, including testing by trial and error, through which the original concept is mod- ified and perfected until it is commercially viable. e Entrepreneurship—the decision to go forward with the effort, the organization of it, and the se- curing of funding for it. e Investment—the act of risking funds for the venture. For the innovative process to succeed in producing an innovation, each of these four components is nec- essary, but the mix may differ widely among applica- tions. Some innovations are the result of sudden in- sights, with little developmental work needed; others may require a laborious and slow development phase with high levels of investment. Nevertheless, all in- novative processes contain each of these components to a greater or lesser extent. When and Where the Innovative Process Occurs Theories of innovation rest largely on underlying views of the innovative process as either deterministic, individualistic, or serendipitous (182). The deter- ministic view holds that innovations come forth when the conditions are right; the individualistic theory stresses the importance of the innovator (an individ- ual or organization) in bringing forth and carrying through an idea; and the serendipity approach stresses the stochastic nature of the process of technological change (182). There is, of course, some truth in each of these ap- proaches. Variability, complexity, and uncertainty are the hallmarks of innovative processes (231). These three factors have substantial influence on the effec- tiveness of policies intended to affect the rate and direc- tion of technological change (232). Innovative proc- esses vary widely among industries and institutions and are not well characterized by simple methods. However, a brief description of how medical and sur- gical procedures that use medical devices come into being may highlight the characteristics of the innova- tive process in medicine.? 2The description presented here is adapted from appendix D of an OTA report entitled Strategies for Medical Technology Assessment (351). App. C—The Innovative Process in the Medical Devices Field 187 Medical and surgical procedures, which often in- volve the use of medical devices, usually begin as user- generated (e.g., physician-generated) innovations. An innovative procedure may involve the modification of an existing procedure (usually in accompaniment with modifications of the devices being used) for applica- tion to a new use. Innovations in procedures frequently arise in aca- demic or academic-associated centers, where physical and professional resources are readily available; a re- search, innovation-seeking atmosphere is encouraged; and contacts with others in the field extend not only nationally, but also globally. Innovators in such set- tings know how to present the innovations in a man- ner that will be technically acceptable and have the prestige that gives them access to professional meetings and journals to publicize their results. Their presenta- tions and publications not only diffuse the innovation to a wider audience, but more importantly, begin to legitimize it. Depending on the claimed innovation’s nature, usually defined in terms of how the innova- tion will revolutionize or at least substantially influ- ence the related area of medical or surgical practice, other academic centers will begin to pursue it. At some point in the innovative process, a prototype device must be developed. This activity may occur in a variety of settings including the academic center, a hospital, a medical device firm, or even a home lab- oratory. The development and refinement of a pro- totype can be a costly and time-consuming part of the innovative process. At this point, several U.S. Government agencies may enter the picture. The National Institutes of Health (NIH) may provide support for the innovator and researchers in other health centers through ran- domized clinical trials, most likely conducted in some of the clinical research centers funded by NIH. A new device or modification of an existing device requires the Food and Drug Administration's (FDA) approval. Increasingly, FDA approves the use of investigational devices for limited testing at the same centers that NIH supports as clinical research centers (or at least to the health institutions in which these designated centers are located). FDA must make a determination of safety and ef- ficacy for market clearance of the device under review. FDA will often make its decision long before NIH reaches a decision and terminates funding for the clin- ical trials. FDA's decision may rest on the narrow ques- tion of the technical functioning and safety of the device. Release of the device to the general market, once premarket approval is given, also tends to speed up the diffusion of the procedure that NIH may be studying. This result, in turn, places more pressure on the Health Care Financing Administration (HCFA) to re- imburse for the procedure. Sooner or later, HCFA may receive a request for reimbursement of the new pro- cedure and will consider information from any clini- cal trials for evidence of safety and efficacy, but only after the device has been approved for marketing by FDA. Conditions Affecting the Innovative Process Despite the variability and uncertainty of the inno- vative process, there are institutional and other con- textual conditions that may influence the process in systematic ways. These conditions fall into four cate- gories: ® conditions affecting the market for the inno- vation, * conditions affecting the ability to appropriate the benefits of the effort to produce the innovation, * conditions affecting the availability of resources to invest in the innovation, and ® conditions affecting the availability and organiza- tion of technical and entrepreneurial know-how. Conditions Affecting the Market for Innovation The market for an innovation depends on the will- ingness of each potential user to pay for its benefits. If a new medical device is to survive after a trial, it must be perceived as worthwhile by the people or organizations who will decide whether or not it will be used (232). Thus, the perceived need for and po- tential benefits of a new device determine the size of the market. Even the “user/innovator,” the individuals or organizations that go about solving their own prob- lems through technological change (446), are likely to assess the potential benefit of the innovation to them- selves and to others in their decisions to devote time and resources to solving a problem. Both the size and organization of the market can be important in determining the willingness to pay for useful innovations (268). For example, potential econ- omies of scale in the production of medical services in certain devices may not be realized because of the small scale of medical care providers (168). If small- scale providers are not organized to share services, then the full benefits of the device cannot be realized by potential users, and the device is unlikely to suc- ceed. Yet, if the potential cost savings are high enough, the availability of a new technology may, with some delay, actually bring about a change in the organiza- tion of the market that allows for its adoption (268). 188 e Federal Policies and the Medical Devices Industry Although it is difficult to sort out the many factors contributing to the emergence of newly integrated health care organizations, changing medical technol- ogy may be one cause. The importance of the market in stimulating innova- tion is indicated by the fact that 60 to 90 percent of successful innovations across many fields have been developed in response to the perceived needs of the market or of users (437). Any factors affecting the size of the market for an innovation, such as changes in the prices of close substitutes, changes in the ability of potential users to pay, and regulatory constraints on use (263), are likely to affect the innovative process. In medical care, the market is determined in large part by mechanisms of third-party reimbursement for care (see ch. 3 for more detail). Russell found that the rate of diffusion of some (but not all) of the medical device innovations that she studied increased with the onset of Medicare coverage (265). Recent work indi- cates that prospective payment approaches can have some retarding effects on the quantity of new medical devices adopted by hospitals (448). Thus, the payment procedures used by insurance companies and other third-party payers may have an important indirect ef- fect on innovative activity in the medical devices in- dustry. Conditions Affecting the Innovators Ability to Appropriate Benefits The need for investment in research, development, and commercialization implies that a potential in- novator must be able to expect a return that will make the investment worthwhile. In addition to an evalua- tion of the potential market, the expected return will depend on the degree to which the innovators can ex- pect to capture or appropriate these benefits in prof- its or perhaps even directly as users. The ability to appropriate benefits affects not only whether innova- tion results, but also what kind of organization or in- dividual undertakes the innovative activity (445). One influence on the ability to appropriate benefits is the market structure of the industry, which influ- ences the rate of imitation and therefore the market share that an innovator can expect over time. The ef- fect of market structure is controversial. Schumpeter and Galbraith postulated that industries with a few dominant firms would be able to appropriate more of 3The innovator's best guess about the potential market may be wrong, for uncertainty and failures of human judgment are inherent in the process. Unless there is some reason to suspect a bias in the direction of error, however, the investment decision can be assumed to deal with the probability of error through its tradeoff of expected risk for return. Government policies such as regulation may increase the level of uncertainty about outcomes of the innovative effort and therefore increase the level of expected return required to justify an R&D investment (97). the benefits of their inventions because they face less of a threat from imitation and would therefore be more innovative than highly competitive industries (274). Other researchers have concluded that high barriers to entry in an industry, particularly in relation to the capital investment required to compete, encourage re- search and development (R&D) by the firms in the in- dustry (66). Fellner has suggested that the effect of monopoly power on the innovative process may dif- fer between product and process innovations (112). Firms in industries in which a few firms hold a substan- tial share of the total market would have less to gain from introducing cost-reducing process innovations than would firms in highly competitive industries, and firms in more competitive fields may have to innovate to keep pace with rivals. Kamien and Schwartz ob- served that the greatest degree of innovation occurs in a market structure where rivalry is greater than in monopoly but less than in perfect competition (178). Empirical evidence testing this hypothesis in U.S. industry is conflicting. Greer and Rhoades found that the rate of process innovation (as measured by produc- tivity growth) was actually higher in concentrated in- dustries, but Scherer points out that this association could be the result of a bias in process innovations toward large-scale operations, which are most likely to predominate in concentrated industries (134,274). Romeo, on the other hand, found that firms in con- centrated industries adopted numerically controlled machine tools (a process innovation) more slowly than firms in more competitive industries (261). The ability to appropriate benefits from investment may also depend on the size and level of diversifica- tion of the innovating firm. Larger firms with greater diversification may be able to apply a process innova- tion across a variety of applications and may there- fore be able to recoup investment costs more readily (230). Empirical studies relating to this hypothesis are inconclusive (274). Despite the large number of companies in the med- ical devices field, especially small ones, concentration in the medical devices categories is simiiar to that in other manufacturing industries. There is some evi- dence, however, that merger activity in medical de- vices accelerated during the latter part of the 1970s (see ch. 2 for details). Government policies can also affect the extent to which a developer captures the benefits of an innova- tion. The patent system is, of course, designed for that purpose, but its power is limited. It is easy to design around some areas of technology, such as electronic circuitry and computer software (142). Also, firms holding critical patents may refuse to license them, thus blocking further technological innovations (142). In short, the ability to appropriate benefits may carry App. C—The Innovative Process in the Medical Devices Field ¢ 189 with it the ability to resist pressure to apply potential innovations. Conditions Affecting the Availability of Resources Several scholars have noted the increasing institu- tionalization of R&D in the post-war period (175,182). Although there is variation across industries and fields of technologies, organized R&D as opposed to indi- vidual efforts have become the predominant source of innovation in this country as well as others. This trend toward institutionalization stems at least partly from the complexity of technology and the increasing need for financial resources and trained manpower to bring forth innovations. Two kinds of resources are needed for R&D: per- sonnel and financial capital. The availability of a pool of adequately trained personnel capable of carrying on R&D should become more important to technologi- cal innovation as the technology base gains in com- plexity. This OTA report does not explore issues of personnel or the role of scientific and technical edu- cation as it relates to industrial innovation in general and to the medical devices industry. Financial capital can take the form of government or philanthropic grants and contracts for R&D, funds generated internally by firms (e.g., undistributed prof- its), and debt or equity instruments (including venture capital arrangements). The flow of these funds depends on the expected return and risk inherent in specific R&D projects, which in turn depend on the market and the appropriability of benefits. Government pol- icies also influence the flow of R&D funds and there- fore the location of R&D activities and the ultimate innovations. As discussed in this OTA report, Government R&D policies influence not only the kinds of projects that are initiated, but also the kinds of organizations in which R&D takes place. Taxation policy also affects the availability of different kinds of capital. Appen- dix G discusses the impact of taxation policy on R&D for medical devices. Conditions Affecting the Availability of Technical and Entrepreneurial Know-How Successful innovation requires the joining of tech- nical and entrepreneurial expertise. Although these areas of expertise need not reside in a single individ- ual, they must be integrated in an appropriate fash- ion. Are there conditions or environments that foster or inhibit the existence and productive use of these skills? A great deal of research has been devoted to deter- mining whether or not the size of the firm has any rela- tionship to its ability to develop innovations success- fully. The size of the organization can be important to innovation for several reasons. First, larger firms may be more able to marshal the technical resources needed to conduct R&D on complex subjects. Second, large firms may be able to appropriate the benefits of innovations more easily than small firms. Third, large firms may have greater access to capital to finance R&D than small firms. Against these possible advantages of large firms is one major advantage held by small firms. Small firms may be less burdened by cumbersome organizational structures that could inhibit coordination and timely decisionmaking on innovation. The interplay of these factors has suggested to some that there may be a threshold size necessary to support the R&D that results in innovation (203,179). Moreover, this thresh- old size is likely to vary from industry to industry. Em- pirical studies of the innovative process do not sug- gest any systematic patterns of advantage for large firms. One recent study, which examined 635 prod- uct innovations marketed during the 1970s, found that small firms accounted for approximately 40 percent of these (124). Other work has found some advantage to size but, again, only up to some threshold (200). In a recent study, The Futures Group examined over 8,000 innovations published in trade journals in 1982 (123).* The number of innovations per employee was 1.43 times higher in small firms (500 employees or less) than in large firms. Innovations were categorized by Standard Industrial Classification (SIC) code. Rates of innovation in five medical device codes are presented in table C-1. With the exception of SIC 3851 (ophthal- mic goods), small firms were over twice as innovative relative to levels of employment as large firms in the medical device industries. There is also evidence from a Louis Harris survey that “the introduction of new medical devices is just as common in small as it is in large plants” (197). About one-half of the establishments with 500 or more employees introduced a significant new medical device in the last decade, while just under half of the firms with fewer than 500 employees reported doing so. (In- deed, more than one-half of the very small firms, 1 to 9 employees, reported such an introduction.) “This study, like others that depend on a sample of published innovations, is subject to possible selection bias. The bias is most likely in the direction of overrepresentation of innovations by large firms and more significant in- novations. Hence, findings showing smaller firms to be more innovative are probably strengthened by this bias. 190 e Federal Policies and the Medical Devices Industry Table C-1.—Rates of Innovation in Five SIC Code Medical Devices Categories? Industry Ss d employment in 1977d Standard Innovations in 1982 (thousands) Classification Small Large Small Large Innovations per employee (SIC) codeP firme firm firm firm small firm : large firm 3693 ....... 10 17 59 25.0 2.49 3841 ....... 36 30 11.7 31.5 3.23 3842e ...... 33 30 17.9 36.0 2.21 3843 ....... 2 0 71 9.2 NAf 3851 ....... 2 9 111 18.9 0.38 Total ..... 83 86 53.7 120.6 2.17 8|nnovations were published in 1982 trade journals. he five SIC codes are as follows: 1) SIC 3693 (X-ray and electromedical equipment), 2) SIC 3841 (surgical and medical instruments), 3) SIC 3842 (surgical appliances and supplies), See ch. 2 for more information. CSmall firms have fewer than 500 employees. Employment in 1977 is used because a lag in journal publication of 4.3 years in a detailed analysis of 375 innovating firms. 4) SIC 3843 (dental equipment and supplies), and 5) SIC 3851 (ophthalmic goods). between invention and innovation was found This analysis excludes four innovations in SIC 2842, because the innovating companies could not be found in published directories. NA indicates information not available. SOURCE: The Futures Group, “Characterization of Innovations Introduced on the U.S. Market in 1982,” contract report prepared for the U.S. Small Business Administration, contract No. SBA-6050-0A-82, Glastonbury, CT, March 1984. On balance, it appears that in the medical device field as in industry in general, small firms play an im- portant role in spurring innovation, but the evidence is limited by the lack of consistent or validated meas- ures of innovation and of any standardized criteria for assessing the relative importance of innovations. In ad- dition, there may be a great deal of variation among industries and types of technologies in the most appro- priate setting for bringing forth innovations. Scherer concludes that the issue of small or large may be ir- relevant when what is needed is a variety of environ- ments capable of responding to technological oppor- tunities wherever they arise (274). Appendix D.—Patent Policy Regarding Medical Devices Introduction The U.S. patent system started with British-based colonial patent systems which continued after the American Revolution. It is derived from a specific pro- vision in the Constitution (357): The Congress shall have the Power . . . to promote the Progress of Science and useful Arts, by securing for limited Times to . . . Inventors, the exclusive . . . Right to their . . . Discoveries. The Supreme Court has interpreted this clause in our Constitution to mean that (132): The Congress in the exercise of the patent power may not overreach the restraints imposed by the stated constitutional purpose. Nor may it enlarge the patent monopoly without regard to the innovation, advance- ment or social benefit gained thereby. Moreover, Con- gress may not authorize the issuance of patents whose effects are to remove existent knowledge from the pub- lic domain, or to restrict free access to materials already available. Innovation, advancement, and things which add to the sum of useful knowledge are inherent requisites in a patent system which by con- stitutional command must promote the progress of . . . useful Arts. This is the standard expressed in the Constitution and it may not be ignored. And it is in this light that patent validity requires references to a standard written into the Constitution . . . There are four types of property rights in informa- tion, or intellectual property —patents, trade secrets, trademarks, and copyrights. Patents give the right to exclude others from using inventive concepts during the life of the patent. Trade secrets, traditionally under State not Federal law, give the owner of a technical or commercial secret the right to prevent someone with access to the secret from disclosing it or using it for personal gain. But if the secret can be discovered in- dependently or is discovered by legitimate means (e.g., from analysis of the product), there is no protection. Trademarks give merchants the right to restrict their use by others who might benefit from the exploitation of established products (e.g., Coca Cola®, Darvon®, SweetnLow®). Copyrights provide the right to exclude others from copying the form of a work of art or a writing, but do not prevent others from using the ideas expressed in the copyrighted work (347). Lately, a property right called a “tangible research property” has emerged separate and distinct from patents, copyrights, trademarks, and trade secrets. For example, in March 1982, Stanford University devel- oped a separate policy on tangible research property to protect Stanford's ownership of “tangible (or cor- poreal) items produced in the course of research proj- ects.” This policy covers such items as “biological materials, computer software, computer data bases, circuit diagrams, engineering drawings, integrated cir- cuit chips, prototype devices and equipment, etc.” (289). There are four types of patents, one of which, the “utility” patent, applies to useful processes, machines, manufactured articles, or compositions of matter. “De- sign” patents protect ornamental designs. “Plant” patents apply to asexually reproduced plants other than tubers or a plant found in an uncultivated state. “Plant variety protection certificates” provide patent- like protection to sexually reproduced plants. Certifi- cates are administered through the U.S. Department of Agriculture. Utility, design, and plant patents are administered through the Patent and Trademark Of- fice in the U.S. Department of Commerce (347). The law on utility patents is as follows (347): ® An invention, to be patentable, must be useful and must be a process, machine, manufactured good, or composition of matter. ® A patent can be granted only for an invention that, at the time of the claim: 1) was not known to others, and 2) was not so obvious that a per- son of ordinary skill in the art could have made the same invention. ® A patent can be granted only to the inventor(s). ® A patent gives the owner the right to exclude others from making, using, or selling the inven- tion in the United States. (There are some impor- tant conflicts between the patent laws of the United States and those of other countries.) ® A patent is granted for 17 years. About 100,000 patent applications are filed per year, of which about two-thirds are eventually granted. The average time from application to action is about 2 years. During this time, a patent examiner determines whether the invention is novel and not obvious (see above), primarily by searching files within the Patent and Trademark Office that contain information on U.S. and foreign patents and on literature such as pro- fessional journals (347). Tables D-1 and D-2 summarize the number of pat- ents granted by the U.S. Patent Office between 1970 and mid-1983. In table D-1, patents are enumerated by the date of the patent grant, while in table D-2, suc- cessful patent applications are listed by the dates when patent applications were first filed. The date when an application is filed is a more accurate reflection of when the technology was developed. Fluctuations in data based on application dates are more likely to re- flect changes in technological activity, since such fluc- tuations would be unaffected by changes in the Pat- ent and Trademark Office's processing of patent applications. For example, the 1979 patent grant data 191 Table D-1.—Patent Activity by Date of Patent Grant, U.S. and Foreign Origin, 1970-83 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 Total .......... 64,429 78,317 74,810 74,143 76,278 72,002 70,226 65,269 66,102 48,8542 61,819 65,771 57,889 24,383b US. origin ..... 47,077 55,984 51,524 51,504 50,650 46,713 44,277 41,484 41,254 30,081 37,356 39,223 33,896 14,144 (Percent) .... (73) (71) (69) (69) (66) (65) (63) (64) (62) (62) (60) (60) (59) (58) Foreign origin. . 17,352 22,333 23,286 22,639 25,628 25,289 25,949 23,785 24,848 18,773 24,463 26,548 23,993 10,239 (Percent) .... (27) (29) (31) (31) (34) (35) (37) (36) (38) (38) (40) (40) (41) (42) aThis number is artificially low because the Patent and Trademark Office issued fewer patents than normal because of a lack of funds to print patents. Includes data only to June 1983. SOURCE: U.S. Department of Commerce, Patent and Trademark Office, Office of Technology Assessment and Forecast, “OTAF Custom Report, All Technologies Report, 1/1963-6/1983” (mimeo), 1983. Table D-2.—Patent Activity by Date of Patent Application, U.S. and Foreign Origin, 1970-83 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 Total ........... 65,942 66,353 63,356 66,278 66,381 65,807 65,695 65,697 64,931 64,081 58,2282 23,8162 1,6472 1ab US. origin ...... 45,851 45580 42,429 42,733 41,830 42,198 41,566 40,652 39,222 37,978 34,403 14,765 1,150 0 (Percent) ..... (70) (69) (67) (64) (63) (64) (63) (62) (60) (59) (59) (62) (70) (0) Foreign origin. .. 20,091 20,773 20,927 23,545 24,551 23,609 24,129 25,045 25,709 26,103 23,825 9,051 496 0 (Percent) ..... (30) (31) (33) (36) (37) (36) (37) (38) (40) (41) (41) (38) (30) (100) apata incomplete because of ag time between application and approval. Includes data only to June 1983. SOURCE: USS. Department of Commerce, Patent and Trademark Office, Office of Technology Assessment and Forecast, “OTAF Custom Report, All Technologies Report, 1/1963-6/1983” (mimeo), 1983. A11snpuj s89iraq |BOIPSIN dy) PUE S8101[0d [eloped e Z61 App. D—Patent Policy Regarding Medical Devices ¢ 193 (see table D-1) are low, not because of a decrease in technological activity, but because the Patent Office issued fewer patents than normal because of a lack of funds to print patents. Table D-2, summarizing successful patent applica- tions by the date of patent application, shows that U.S. patents have remained at approximately 65,000 per year through the 1970s (data for 1980 and subsequent years are incomplete because of the delay between ap- plication and final ruling by the Patent and Trademark Office). During this period, patents of foreign origin increased from 30 to 40 percent of successful applica- tions. About one-fourth of these patents of foreign origin were Japanese, closely followed by patents from West Germany (217). Table D-3 summarizes 1981-83 data for selected in- dexes. In addition to the fact that about 40 percent of patents were of foreign origin, more than 75 percent were of corporate origin, about 2 percent were U.S. or foreign-government owned, and about 7 percent were owned by a foreign-resident inventor but as- signed to a U.S. organization. A patent can be sold (assigned), or it can be licensed on an exclusive or nonexclusive basis. An exclusive licensee has the right to enforce the patent. Nonex- clusive licenses, granted to more than one party, are simply promises that licensees will not be sued for pat- ent infringement. Payment for a license is usually by fee (e.g., $10,000 per year) or by royalty, based on some measure of income such as frequency of use of the invention or percent of sales of the invention (or products incorporating it). Patent owners police their own patents. If they believe that their patents are being infringed, they may let unauthorized uses continue and try to collect li- censing fees from the unauthorized users. But if the users refuse to cooperate, patent owners must go to court to obtain an injunction against the unauthorized use and to collect damages. Table D-3.—Data on Patent Approvals, Selected Indexes, 1981-832 Percent corporate-owned ..................... 76.87% Percent government-owned ................... 2.37% Percent foreign-origin ........................ 41.06% Percent US-owned of foreign ................. 7.17% apefinitions: Percent corporate-owned: 1981-83 U.S. patents assigned to corpor- taions/1981-83 patents x 100. Percent government-owned: 1981-83 U.S. patents assigned to the U.S. or foreign governments/1981-83 patents x 100. Percent foreign-origin: 1981-83 U.S. patents with foreign resident inventor/1981-83 patents x 100. Percent U.S.-owned of foreign: 1981-83 U.S. patents with a foreign resi- dent inventor that are assigned to a U.S. organization/1981-83 patents with a foreign resident inventor x 100. SOURCE: U.S. Department of Commerce, Patent and Trademark Office, Office of Technology Assessment and Forecast, “OTAF Custom Report, All Technologies Report, January 1963 to June 1983 (mimeo), 1983. The U.S. patent system is currently undergoing ma- jor changes. In July 1981, reexamination proceedings were initiated under which anyone can request that a patent be reexamined (accompanied by a $1,500 fee). The Patent and Trademark Office can refuse to re- examine on the basis that no substantially new ques- tion was raised. In the same law (Public Law 96-517) that authorized reexamination (in which other parties can challenge a patent), Congress also required the Pat- ent and Trademark Office to submit a plan to Con- gress by December 1982 on modernizing its files. Patent protection is intended to stimulate invention by giving potential inventors the exclusive right to any benefits for a substantial time. A patent is also granted as a reward for the early disclosure of the invention to the public and not as a reward for either its discov- ery or for investment in its commercial development and exploitation. If the public would benefit eventually from the invention through its public disclosure or commercial use, no reward would be necessary and no patent would be given (101). This is the reason for the patenting requirements of novelty and not being obvious to someone working in the same field, and for the requirement that the patent application must contain enough information so that someone else can copy it. Some International Aspects of Patents Only some of the international aspects of patents are discussed here. One example of differences between the United States and other countries in the area of patent law is the concept of “prior art.” In the United States, there is a 1-year grace period between publish- ing of the invention (e.g., of a new technique in a pro- fessional journal) and filing for a patent. Most univer- sities routinely require researchers to report promptly inventions with potential commercialization so that the university can assess their potential and file for a pat- ent. Most other countries do not have such a grace period. Another example is that under current U.S. patent law, it is legal to import a product made in another country by a process covered by a U.S. patent with- out permission of the patent holder. A proposal to make this an infringement of the U.S. patent was reportedly part of the Patent and Trademark Office's 1983 legislative proposals (220). Under the Paris Convention of 1883, patent holders are given a commercial monopoly (subject to certain conditions) for their inventions in 92 signatory coun- tries. Patent holders must publish details of their discoveries in the signatory countries for other scien- tists to study, but the invention may not be copied for 194 e Federal Policies and the Medical Devices Industry profit. Member countries may allow rival manufac- turers to produce the invention if patent holders abuse their monopoly, for example, by neglecting to produce the invention in the affected countries. The Paris Convention is administered by the United Nations’ World Intellectual Property Organization. In the third conference on revisions of the Paris Conven- tion for the Protection of Industrial Property, held in Geneva in October 1982, the main issue was a propos- al that would make it easier for developing countries to confiscate and manufacture patented inventions. Third-world governments had wanted a provision giving them the right to take over and manufacture on an exclusive basis any potential invention if the original patent holder did not produce it in their coun- try within 30 months of receiving a patent. The intent was to force foreign manufacturers to produce their inventions in the developing country instead of pro- ducing them elsewhere and importing them. Third- world countries claimed that large companies that hold most patents can use imports to undercut a local man- ufacturer allowed to use their technology, so an ex- clusive license barring even the original patent holder was necessary for local production. The proposal would also have allowed a registered patent to be con- fiscated altogether after 5 years. The developed countries opposed the proposal as an expropriation of private property and because large companies would become more secretive about their inventions and reluctant to invest in developing coun- tries. Chemical and pharmaceutical companies were thought to be most vulnerable, because their patented products are relatively easy to make once their for- mulas are known. Prior to the October 1982 conference, Japan and the West European countries had agreed to the proposal, arguing that developing countries would find a way to do it anyway, and that defining the conditions under which exclusive licenses were granted would give more, not less, protection. At the conference, the United States offered a compromise proposal that would grant nonexclusive licenses, but no agreement was reached (194). Patents and New Product Development The value of patents in the decision to undertake innovative activities depends on the type of invention and on the type of decisionmaker. For example, the pharmaceutical industry rarely pursues the develop- ment and regulatory approval processes for a new drug unless it can be patented. Also, recall that drugs and other chemicals, once identified, are relatively easy to copy. In the 97th Congress, extension of the patent term to recover time lost to the regulatory approval process was the Pharmaceutical Manufacturers Asso- ciation’s number one legislative priority, but it lost nar- rowly in the supplemental session of Congress. In con- trast, much of the innovation in the electronics industry has occurred without patents. The importance of patents to small businesses is also variable. Many small firms depend on trade secrets rather than on patents. Reasons include the expense of obtaining or having to defend patents, and the uncertain outcome if the patent is challenged (234). But the smaller of the small firms usually consider patents to be more critical than do large businesses. There are anecdotes of the importance of patents in securing financial support. In interviews conducted for another OTA study (347), eight venture capitalists dis- tinguished between two types of investments: 1) those that rely on a firm's management team and rapid ad- vances in technology to provide protection from com- petition, with the emphasis on short-term payouts on the investments; and 2) technologies that require a long research and development period, for which patents become almost a prerequisite for investment. In essence, the confidence that is placed in patents is a key to determining the incentives for innovation provided by patents. Little is statistically known about these factors, but it appears that the degree of confi- dence varies over a wide range. For products that require large capital costs, such as automobile manufacturing, patents may have little * bearing on investment decisions because of the limited ability of a competitor to enter the market. But patents have another use for both large and small firms— defensive use to prevent others from stopping the patent holder in proceeding with his or her invention. One example is in the development of the computed tomography (CT) scanner (258): Before CT, few X-ray companies bothered with pat- ents, since all the X-ray companies recognized that no one company had a monopoly on the patents, each would have had to license from the other to stay in business—the result being “why bother with patents?” EMI, who was new to the X-ray business, heavily patented their CT designs, and by the end of the dec- ade was requiring substantial royalties from all the CT suppliers. As a defensive measure, the X-ray com- panies substantially had to change their patent prac- tices; for example, we [General Electric] went from having the part-time use of one patent attorney to hav- ing three full-time patent attorneys. This, I believe, was totally the result of EMI's changing the practice of an industry. App. D—Patent Policy Regarding Medical Devices ¢ 195 Patenting of Medical Devices The U.S. Patent and Trademark Office classifies patents into 400 to 500 functional categories, and no specific category encompasses all medical devices. The Food and Drug Administrations (FDA) Office of Eco- nomic Analysis decided which categories should be considered medical devices, and further categorized these devices as either “low” or “high” technology, depending on how “sophisticated” the device was (390). Table D-4 identifies which types of medical devices have been categorized by FDA's Office of Economic Analysis as low or high technology and their patent categories and subcategories as classified according to the Patent and Trademark Office. Figures 2 and 3 in chapter 5 summarize U.S. and foreign medical device patents for these low- and high-technology medical devices by application date for 1968 to 1979. Low tech- nology patents increased in the early 1970s from about 800 per year to a peak during 1973 to 1974 of between 1,200 to 1,300 per year and remained at that general level for the rest of the 1970s. Patents for high-tech- nology medical devices, on the other hand, continued to increase throughout the 1970s, doubling from more than 500 per year in 1970 to more than 1,000 per year by 1979. In sum, in the 1970s: 1) there was a modest increase in the annual number of successful patents for medi- cal devices, while there was essentially no increase in annual total patents granted; 2) patents for low-tech- nology medical devices increased in the early 1970s but remained essentially constant for the rest of the dec- ade, while patents for high-technology medical devices continued to increase throughout the decade; and 3) while the percent of foreign-origin patents increased for both medical devices and all inventions by approx- imately 10 percent, the percent of foreign-origin med- ical device patents (30 percent) was still lower than the percent for all patents (40 percent) by the end of the 1970s. Table D-4.—High- and Low-Technology Medical Devices as Classified by FDA’s Office of Economic Analysis High-technology devices: A. Diagnostic equipment . Cardiac devices (128) 695-7152 . Vascular devices (128) 669-694 . Respiratory devices (128) 716-730 . Stimulators, neurological, etc. (128) 731-746, 639-644 . Radiation (128) 653-667 . Other (128) 630-782, minus above codes plus 3-23 B. Respiratory methods 1. Mixing (128) 203.12-204.14 2. Supply (128) 204.18-205.26 plus 207.14-207.18 3. Substance removal (128) 205.27-207.13 4. Other (128) 200.11-200.23 and 204.15-204.17 C. Electrical systems and energy applicators (128) 419R-804 D. Implantable artificial body members 1. Cardiovascular (3) 1.4-1.7 2. Legs, arms, bones, etc. (3) 1.913-2 3. Other (3) 1-1.2 and 13-36 E. Dialysis and blood filters (210) 321A-321B and (422) 44-48 F. Miscellaneous (includes incubators, hearing aids, magnetic devices) (128) 1R-1.5 and (181) 126-137 Low-technology devices: Kinesitherapy (128) 24R-67 Orthopedic (128) 68-80J, 81A-81R, 581-623 Bandages and trusses (128) 82-171 Medicators (604) 1-7, 11-19, 23-42, 46-72, 77-93, 104-170, 173-238, 239-263, 272-279, 285-302, 303-311, 403-416, 890-897 Instruments (604) 8-10, 43-45, 94-103, 171-172, 264-271, 280-284 F. Dental 1. Orthodontics (433) 2-24 2. Apparatus (433) 25-166 3. Prosthodontics (433) 167-214 G. Ophthalmic 1. Examining equipment (351) 1-40 2. Frames (351) 41-158 3. Lenses (351) 159-177 H. Miscellaneous (includes receptors, baths, canes) (604) 20-22, 73-76, 312-377, 378-402, (128) 362-403 @Numbers refer to categories (in parentheses) and subcategories according to the Manual of Classification, U.S. Department of Commerce, Patent and Trade- mark Office. SOURCE: US. Department of Health and Human Services, Food and Drug Admin- istration, Office of Economic Analysis, Rockville, MD, personal com- munication, December 1983. OOO WN = com> m Appendix E.—Method Used for OTA’s Analysis of Applications to the National Institutes of Health for Small Business Innovation Research Grants The data in table 31 (see ch. 4) are the result of an OTA analysis of the Small Business Innovation Re- search (SBIR) grant applications submitted to the Na- tional Institutes of Health (NIH) for funding in Oc- tober 1983. OTA obtained copies of all applications submitted to NIH. A 50-percent-interval sample of ap- plications (one of every two) was selected for analy- sis. (The total sample of 297 was selected from the 593 applications submitted.) Using the Food and Drug Administration’s defini- tion of a medical device, OTA divided the NIH SBIR grant applications into three categories: ® biotechnology applications (includes medical de- vice and other applications involving biotech- nology), ® medical device applications (includes medical de- vice applications not using biotechnology), and e all other applications. An application was categorized as a biotechnology ap- plication if the proposed research and development in- 196 volved the use of recombinant DNA or other recently developed genetic, cell fusion, or bioprocessing tech- niques. An application was classified as a medical de- vice application if, first, it did not use biotechnology and, second, it involved either research leading to the actual development of a medical device or research into techniques or products that would subsequently be used in the development of a medical device (i.e., the development of new materials for use in a medi- cal device). Because judgment was involved in categorizing the applications, inter-rater reliability was tested by hav- ing an independent rater analyze 36 randomly selected applications from the sample (approximately 10 per- cent of the sample). The two independent raters agreed on 26 out of the 36 applications (72 percent). This is significantly higher than the level that would be ex- pected by chance, but nevertheless allows a substan- tial level of variation. Appendix F.—The Database of Venture Economics, Inc., on Sources of Financial Capital Venture Economics, Inc., the research and con- sulting division of Capital Publishing Corp., maintains an extensive database of information on the U.S. ven- ture capital industry. The Venture Economics database currently tracks investments by the leading venture capital firms, both independent private and corporate groups, which account for more than 80 percent of the U.S. venture capital industry's total investment activ- ity. In addition, the database covers the investment activities of Small Business Investment Corporations (SBICs) involved in classic venture capital type in- vestments. The database does include a small degree of investment by foreign sources in U.S. companies as well as investment from unidentified sources, some of which may be non-venture-capital institutional funding. Through extensive data collection efforts, Venture Economics has been able to research and computerize information on more than 4,300 companies that have received venture capital financing since the 1960s. Ef- forts to date have focused on the computerization of the following information on each portfolio company: ® company name and address, ® business description, ® industry or business codes including the Stand- ard Industrial Classification code and more spe- cific codes developed by Venture Economics, ® status of the firm (public or private), ® year founded, and for each round of financing: — amount of financing, — date of the financing round, — stage of development of the company, and — venture capital investors. Table 30 in chapter 4, which listed the percentage of U.S. venture capital funds invested in medical im- aging, other medical products, industrial products, and electronics, was based on the Venture Economics database's recorded venture capital investments for 1982. Although the investments recorded by the Ven- ture Economics database do not account for all ven- ture capital investments (see table F-1), in aggregate, they do offer a representative picture of venture capi- tal investment activity. The categories of investors cov- ered by the database are presented in table F-2. Medi- cal imaging and the three other industry/product categories mentioned above, which were used in table 30 to classify firms receiving venture capital funds, are shown in table F-3. Definitions of the stages of financ- ing used to categorize financing rounds in table 30 are shown in table F-4. Table F-1.—Total Investments by the U.S. Venture Capital Industry, 1978-82 (millions of dollars) Investments Total venture recorded by the capital Venture Economics Year investments database 1978 LLL. $ 550 $ 282 1979 LLL 1,000 500 1980 ............. 1,100 803 1981... 1,400 1,400 1982 ............. 1,800 1,760 SOURCE: Venture Economics, Wellesley Hills, MA, “Venture Capital Investment in the Medical Health Care Field,’ contract report prepared for the Office of Technology Assessment, August 1983. Table F-2.—Categories of Investor Types Covered by the Venture Economics Database Independent private (225 investors): Independent private funds SBIC subsidiaries of private funds Corporate financial (120 investors): SBIC and non-SBIC subsidiaries of financial groups ‘Other investments by financial groups including insurance companies Corporate industrial (125 investors): Venture capital funds wholly or jointly funded by nonfinancial corporations Direct corporate venture capital investors SBIC subsidiaries of these industrial corporations Nonaffiliated SBICs (140 investors): Public and private SBICs not affiliated with any of the above investor types Other (240 investors):® Government affiliated groups Community development corporations Universities Individuals Foreign investors aThe number of investors in each category includes investment groups that are no longer active or that make only occasional investments. bThe majority of these are United Kingdom funds that do not invest in the United States on a regular basis. SOURCE: Venture Economics, Wellesley Hills, MA, “Venture Capital Investment in the Medical Health Care Field,’ contract report prepared for the Office of Technology Assessment, August 1983. 197 198 e Federal Policies and the Medical Devices Industry Table F-3.—Four Product Categories Used in the Venture Economics Database Medical imaging: X-rays CT scanning Ultrasound imaging Nuclear imaging Other imaging Medical products and services: Diagnostic (not including medical imaging): Diagnostic services Diagnostic test products and equipment Other diagnostic Therapeutic: Therapeutic services Surgical instruments and equipment Pacemakers and artificial organs Drug delivery and other therapeutic equipment Other therapeutic including defibrillators Other medical or health related: Disposable products Handicap aids Monitoring equipment Other medical or health related (not including pharmaceu- ticals, fine chemicals, or hospital and other institutional management including management services and leasing) Industrial products: Advanced materials (including production processes) Industrial automation Industrial equipment and machinery Chemicals Pollution and recycling equipment Other industrial products Other electronics industry segments: Electronic components: Semiconductors Microprocessors Controllers Circuit boards Display panels Other electronic components Batteries Power supplies Electronics-related equipment: Semiconductor fabrication equipment and wafer products Component testing equipment Other electronics-related equipment Laser related Fiber optics Analytical and scientific instrumentation: Chromatographs and related laboratory instrumentation (including spectrometers) Other measuring devices (including infrared gas analyzers, moisture analyzers) Other analytical and scientific instrumentation Other electronics-related equipment: Military electronics (excluding communications) Copiers Calculators Other electronics related SOURCE: Venture Economics, Wellesley Hills, MA, “Venture Capital Investment in the Medical Health Care Field,” contract report prepared for the Office of Technology Assessment, August 1983. Table F-4.— Definitions of Stages of Venture Capital Financing Early stage: Seed—A relatively small amount of capital provided to an inventor or entrepreneur to prove a concept. It may involve product development but rarely involves initial marketing. Startup—Financing provided to companies for use in product development and initial marketing. Companies may be in the process of being organized or have been in business a short time (1 year or less), but have not sold their product commercially. Generally such firms would have assembled the key management, prepared a business plan, and made market studies. First stage—Financing provided to companies that have expended their initial capital (often in developing a prototype) and require funds to initiate commercial manufacturing and sales. Expansion: Second stage—Working capital for the initial expansion of a company which is producing and shipping and has growing accounts receivable and inventories. Although the company has clearly made progress it may not yet be showing a profit. Third stage—Funds provided for the major growth expansion of a company whose sales volume is increasing and which is breaking even or profitable. These funds are utilized for further plant expansion, marketing, and working capital or development of an improved product. Fourth stage—The last round of private financing prior to, but not in anticipation of, a public offering or prior to the point at which a company can qualify for creditoriented institutional term financings. This round may enable institutional term financing or may involve turnaround aspects. Bridge financing—Financing for a company expecting to go public within 6 months to a year. Often bridge financing is so structured that it can be repaid from proceeds of a public underwriting. It can also involve restructuring of major stockholder positions through secondary transactions. This would be done if there were early investors who wanted to reduce or liquidate their positions, or if management had changed and the stockholdings of former management, their relatives and associates, were to be bought out to relieve potential overhead stock supply when public. Leveraged buyouts and acquisition: Acquisition for expansion—Funds provided to a firm to finance its acquisition of another company. Management/leveraged buyout—Funds provided to enable operating management to acquire a product line or business (which may be at any stage of development) from either a public company or private company (often such companies are either closely held or family-owned). This usually involves revitalization of the operation, with entrepreneurial management acquiring a significant equity interest. Other: Turnaround—Financing provided to a company at a time of operational or financial difficulty with the intention of “turning around” or improving the company’s performance. Secondary purchase—Purchase of securities from another venture capital firm, other stockholders, or on the open market. SOURCE: Venture Economics, Wellesley Hills, MA, “Venture Capital Investment in the Medical Health Care Field,” contract report prepared for the Office of Technology Assessment, August 1983. Appendix G.—Tax Policy and Research and Development on Medical Devices’ Introduction Much attention has been paid to potential effects of tax policy on incentives for innovation. Renewed in- terest in this question has recently been prompted by enactment of the Economic Recovery Tax Act of 1981 (ERTA) and the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). As a result of both ERTA and TEFRA, basic changes were made in both the personal and the corporate income tax including: 1) changes in marginal tax rates on personal income, 2) changes in the tax rules for depreciation of capital goods, and 3) enactment of new provisions applying to research and development (R&D). Assessing the impact of these tax changes on the fi- nancial incentives for innovation generally, let alone innovation in medical devices, is extremely complex. However, it is possible to identify two distinct ways in which tax policy changes such as ERTA and TEFRA can affect incentives for innovation. First, tax incen- tives may alter the expected after-tax returns received by prospective purchasers of goods that embody in- novations, thereby stimulating, or inducing, the de- mand for such innovations. Second, both personal and corporate income taxes will cause after-tax prices in capital markets to diverge from pre-tax prices. Both the size of this divergence and its pattern among dif- ferent types of investments may influence the will- ingness of firms and individuals to invest in R&D and innovation. Taxes and Induced Innovation There is some evidence that the level of innovative activity in the development of particular goods is related to the overall level of demand for those goods. A particularly important example of such induced in- novation is the case of capital goods innovation, where: several empirical studies have shown that the level of capital spending by industry affects the level of innova- tion in capital goods (273, 276). Because ERTA/TEFRA permit firms to deduct the costs of depreciable assets more rapidly than was previously allowed, these tax policy changes are expected to stimulate greater capi- tal spending by industry. According to the induced- innovation hypothesis, such increased capital spending should also stimulate innovative activity among those firms producing capital goods. This appendix was written for OTA by Barth and Cordes (27). Many medical devices are clearly capital goods. However, the market for medical devices differs from the market for other capital goods in one important respect. Because many of the purchasers of medical devices are not subject to taxation, their demands for medical devices should not be directly affected by tax rules governing depreciation of capital goods. Thus, the tax provisions of ERTA/TEFRA may be expected to have a smaller impact on the capital spending deci- sions of purchasers of medical devices than of pur- chasers of other capital goods. This situation implies that any induced innovation attributable to ERTA/TEFRA will also be less in the case of medical devices than other capital goods. Of course, TEFRA contained a section specific to Medi- care payment of hospitals, which, with its subsequent modifications under the Social Security Amendments of 1983 (Public Law 98-21), dramatically altered the incentives of hospitals to purchase medical technology (see ch. 3 for details). Another, perhaps more important, way in which the tax code can affect the demand for medical devices is through the tax treatment of employer-paid health benefits. Because such benefits are typically treated as nontaxable fringe benefits, employees, particularly those facing high marginal tax rates, have a tax incen- tive to receive part of their labor compensation in the form of such benefits. The growth of health benefit plans has been one of a number of factors contribut- ing to growth in demand for health services during the postwar period, and this growth in demand may also have encouraged innovations in medical devices. Although the tax-exempt status of fringe benefits has not been affected by ERTA/TEFRA, there has been some support for changes in tax law which would limit the tax exemption currently enjoyed by all fringe benefits, included employer-paid health benefits. If these changes were enacted, it is likely that both the level and composition of demand for health services would be affected, and this change in turn could have some impact on the level and type of R&D in the med- ical devices industry. Taxes and Suppliers of Innovation The ultimate suppliers of innovations are the in- dividuals or firms who choose to allocate resources to R&D rather than to other investment projects. In part, such choices are made outside the boundaries of the firm in external capital markets by individual investors ~ who must decide how to allocate their portfolios of 199 200 e Federal Policies and the Medical Devices Industry wealth among different investments. In part, such choices are made within the firms by managers who must choose among competing uses of a firm's capital budget. In both cases, however, the tax treatment of different investment options is an important factor in the ultimate investment decision. Two alternative investments may be equally pro- ductive before the income from such investments is taxed and yet earn different after-tax returns if one in- vestment is taxed relatively more heavily than the other. In such an event, two investments which are equally attractive insofar as social returns are con- cerned are not equal in the eye of the prospective in- vestor, who will choose the investment with the higher after-tax return. In the case of R&D investments, there are two prin- cipal ways in which the tax code affects their after- tax return compared to other investment activities. The first is the tax treatment of capital gains. The second is the tax treatment of inputs specific to the innova- tion process. Taxation of Capital Gains The expected returns on an investment may be realized through annual flows of income, through cap- ital gains or losses resulting from changes in the asset price of the investment, or through some combination of annual flows and changes in asset values. In the absence of taxation, the manner in which the return was expected to be received would be irrelevant to the ultimate investment decision. All that would matter would be the total expected return (annual expected flows plus or minus capital gains and losses) and the expected risk (the variance of realized returns around the total expected return). However, because capital gains and capital losses are treated differently from income under U.S. income tax, investments whose returns are realized primarily through capital gains or capital losses will be evaluated on a different after-tax basis from investments whose returns are realized through annual flows of ordinary income. At present, capital gains are not taxed until they are actually realized into cash through sale of the asset. More importantly, if the asset is held for longer than 1 year, the capital gain that is realized is taxed at a rate which is generally 40 percent of the tax rate ap- plied to ordinary income. Thus, for example, if a per- son's tax rate on ordinary income were the maximum rate of 50 percent, the tax rate applied to each dollar of long-term capital gain would be 20 percent. If the investment should prove unsuccessful, and a capital loss is realized, the loss may be offset dollar for dollar against capital gains. However, if reported capital losses are greater than the capital gains, the net capi- tal loss may be only partially applied as a deduction against ordinary income. In effect, the U.S. tax system provides preferential treatment to investments which pay off in the form of capital gains, while providing less than complete tax offsets to investments which result in capital losses. Assessing the impact of such a system on the propen- sity of investors to take risk—and by implication to invest in innovative activities—is an extremely com- plex task, and the conclusions that emerge from such an assessment depend on the standard used for com- parison. If the alternative is a tax system which taxed capi- tal gains in full but also allowed full and complete deductibility of capital losses, it would be impossible to ascertain on theoretical grounds which of the two tax regimes—the current one, or the alternative—is the most favorable to risk-taking because the differences would work in opposite directions. However, com- pared with an alternative system which taxed capital gains the same as ordinary income but continued to allow only partial tax offsets for capital losses, pref- erential tax treatment of capital gains encourages more risk-taking. That is, given that loss offsets are incom- plete, partial rather than full taxation of capital gains may be one way of preserving incentives for risk- taking. Two groups of individuals for whom the tax treat- ment of capital gains would appear to be particularly important are the entrepreneur-founders of new ven- tures and the venture capitalists who provide exter- nal financing to such ventures. Those who choose to become entrepreneurs have in effect chosen to forgo relatively certain returns to their human capital (i.e., labor) which could be earned from salaried employ- ment, as well as returns to any personal financial cap- ital they invest, in order to develop an idea or inven- tion into a new product or service. Presumably, this decision is motivated by a variety of considerations and is certainly not limited to tax factors. However, the fact that the expected returns to entrepreneurship will typically be realized in the form of increases in the value of the entrepreneur's ownership share in the firm, which in turn will be taxed favorably as capital gains, would at the margin en- courage rather than discourage entrepreneurship. In- deed, there is some empirical evidence that the pref- erential tax treatment of capital gains has influenced the decision of individuals between salaried employ- ment and entrepreneurship (151). Similar considerations apply to individual venture capitalists. Although such persons are not themselves actively engaged in the development of innovations, App. G—Tax Policy and Research and Development on Medical Devices © 201 they typically share in both the risks and rewards of entrepreneurship through equity participation in the entrepreneurial firm. The fact that any returns to such participation are likely to be realized through apprecia- tion in stock values, and therefore to be taxed fa- vorably as capital gains, would, at the margin, en- courage the commitment of venture capital. Data provided to OTA on the organized venture capital market suggest that venture capitalists are more likely to commit funds to the early stages of firm de- velopment in the case of medically oriented ventures than they are in the case of other industrial ventures (see table 30 in ch. 4). The data also show that capital provided to medical device ventures is more likely to come from private, independent sources than from corporations or small business investment companies (443). These two considerations imply that individual tax incentives which encourage the commitment of risk capital may be of special importance to innovation in medical devices. Finally, the current tax treatment of capital gains interacts with the double-taxation of dividends at the corporate level to encourage earnings retention rather than dividend payout. If earnings are paid out in dividends, such income will be taxed in full at ordinary ‘income tax rates. However, if the earnings are retained and reinvested, stockholders can defer paying personal taxes until any expected capital gains are realized through sale of stock, and then do so at preferential capital gains tax rates. As a result, the effective tax on income from corporate equity is less under earn- ings retention than under dividend payout. At the margin, this encourages firms to retain earnings and, if retained earnings are an important source of funds for some innovations, enhances the financial resources available for innovative activities. The current tax treatment of capital gains would ap- pear to provide benefits to investments in medical de- vice innovations which are equal to those provided to other risky investments. However, the overall value of the tax preference on capital gains to the highest income investors has been somewhat reduced by ERTA, which lowered the maximum tax rate on “unearned income” from 70 to 50 percent. Corporate Tax Policy In the case of relatively established firms, the deci- sion to engage in R&D requires that resources be used to develop and produce a new product which could instead be used to enhance the firm's ability to pro- duce its existing products. If the firm's ultimate objec- tive is to maximize its value, this implies that capital should be allocated to R&D up to the point where the last dollar allocated earns a risk-adjusted expected 25-406 0 - 84 - 14 after-tax return equal to that earned from a dollar in- vested in a more traditional investment activity. If the tax code is neutral in its treatment of the pro- ductive inputs used in different investment projects, tax considerations will not influence the firm's alloca- tion of capital among competing investment activities. However, if the tax code favors the use of certain in- puts, and if these favored inputs are specific to cer- tain types of investment projects, tax considerations will affect the amount of capital allocated to different projects. In effect, investments that use tax-favored in- puts will be encouraged, because they will need to earn a lower pre-tax return in order to earn a given after- tax return than will investments that do not use tax- favored inputs. Tax Treatment Before and After ERTA/TEFRA.— In the case of R&D, the issue is whether the inputs used for R&D are treated more or less favorably than in- puts used in other investment activities. The two prin- cipal inputs needed to develop innovations are tangi- ble capital in the form of depreciable assets and intangible capital arising from expenditures on R&D. Prior to the enactment of ERTA/TEFRA, tangible capital used in conducting R&D was treated the same as tangible capital used for other purposes. Firms using such capital were entitled to claim an investment tax credit on new equipment, but not structures, and could then claim a stream of depreciation deductions over a number of years based on guidelines established by the Department of Treasury. However, neither the amount of the investment credit nor the speed at which the asset could be depreciated were related to the type of investment project in which the asset was used— i.e., to whether the asset was used in R&D or in a more traditional investment activity. Other costs of R&D were, however, given special treatment. Specifically, section 174 of the Internal Rev- enue Service Code allowed the salaries and expenses incurred to develop R&D to be deducted immediately in the year incurred. This “expensing” of R&D was viewed as preferential treatment because R&D sala- ries and expenses were seen as part of the costs of ac- quiring an intangible asset which was capable of pro- viding services to the firm over a number of years. Under this view, expensing confers favorable tax treat- ment on R&D activities. Enactment of ERTA/TEFRA has altered the relative position of different kinds of investments in three ways. First, though the rules governing R&D expens- ing were not changed by ERTA/TEFRA, the rules governing depreciation of other capital assets have been liberalized considerably by adoption of the Ac- celerated Cost Recovery System (ACRS). Second, for the first time, tax depreciation rules treat equipment used in R&D as different from equipment used in other 202 » Federal Policies and the Medical Devices Industry activities. Third, for the first time, R&D outlays which qualify for expensing may also qualify for a tax credit. In the remainder of this section, we examine how these measures—both singly and in combination—affect the relative attractiveness of innovative investments gen- erally, and innovation in medical devices specifically. Accelerated cost recovery. ACRS, enacted as part of ERTA with some modifications in TEFRA, speeds up the rate at which the costs of using depreciable assets may be recovered. Depreciable capital assets (e.g., equipment and buildings) are important inputs into R&D. However, the capital intensity of R&D differs among projects so that the impact of changes in cost recovery rules will be greater for some types of R&D projects than for others. Liberalized cost recovery favors R&D projects that are relatively capital-intensive. Detailed data on the capital intensity of R&D in dif- ferent industries do not exist. However, National Science Foundation (NSF) data can be used to con- struct a crude index of factor intensity in R&D: the ratio of R&D expenditures to scientists and engineers employed in R&D. Other things being equal, this ratio should be higher in industries in which R&D is more capital-intensive. Based on this ratio, one may there- fore ascertain whether R&D activities in any given in- dustry benefit relatively more or less from ACRS. While NSF data do not permit the above ratio to be calculated specifically for medical device producers, the ratio can be calculated for producers of optical, surgical, and photographic equipment (Standard In- dustrial Classification (SIC) codes 383-387). Between 1976 and 1979, the R&D capital-intensity ratio for this industry group exceeded the average ratio for all man- ufacturing industries. This suggests that the R&D in- vestments of medical device producers in these SIC codes benefit relatively more from ACRS than do R&D investments of other manufacturers. The overall effect of the ACRS on R&D in medical devices is unclear, however, because ACRS moves the tax treatment of non-R&D capital closer to that of R&D expensing. This reduces the relative attractive- ness of using business funds for R&D expenditures that qualify for expensing. While ACRS has a scale effect favorable to all investment projects using depreciable capital, it has a substitution effect which tends to fa- vor capital investments that do not involve R&D (27). That is, while ACRS reduces effective tax rates on all investments, it reduces them more for investment proj- ects which are relatively less intensive in the type of R&D which qualifies for expensing. The net effect of the two effects on R&D in medical devices is unknown. Special treatment of R&D equipment. One provi- sion of ACRS which applies specifically to depreciable assets used in R&D is the assignment of all R&D equip- ment to the “3-year recovery class.” Because of this provision, all equipment used in R&D must be depre- ciated over 3 years, even though the ACRS guidelines would normally require that the same equipment be depreciated over a longer period of time if used for other purposes. Because non-R&D equipment is as- signed to either the 5- or 10-year recovery class, this provision would appear to favor R&D by allowing the capital costs of equipment to be deducted more rapidly if the equipment is used for R&D rather than in other activities. However, while equipment used in R&D may be written off more rapidly, all equipment in the 3-year recovery class qualifies for a smaller investment tax credit—6 percent—than equipment in the longer lived asset classes, which is eligible for a 10-percent investment credit. Under ERTA, the disadvantage of receiving a smaller investment credit was large enough to offset the advan- tage of more rapid writeoff. However, because of changes made in TEFRA which reduced the value of the writeoff, this no longer appears to be the case. Given the current set of tax rules, the net effect of grouping R&D equipment into a special recovery class is favorable to equipment used in R&D. (For a more elaborate discussion, see Barth, Cordes, and Tassey, 1984 (27); Collins, 1983 (65); Zakupowsky and Sunley, 1982 (466).) Tax credit for incremental R&D. As a result of ERTA, firms can also claim a tax credit for certain R&D spending. The amount of the credit equals 25 per- cent of the amount of which “qualified research ex- penses” during a year exceed the base period level of such expenses. The base period level is the average qualified expenses of the 3 preceding years, while qualified expenses are those defined in keeping with section 174 (the R&D expensing provision). If the firm pays other parties to conduct R&D, 65 percent of such purchases are deemed to be qualified research expenses. The R&D credit is scheduled to expire as of January 1, 1986. Predicting the impact of the existing R&D tax credit is difficult for two reasons. First, the R&D credit is temporary rather than permanent. Second, the amount of the credit is based on incremental rather than total expenditures. A detailed analysis of the effect of the R&D credit is beyond the scope of this discussion (see Barth, Cordes, and Tassey, 1984 (27) for a complete treatment), but it is possible to make a rough assess- ment of the benefits which producers of medical de- vices have thus far derived from the R&D credit in relation to firms in other industries. In a preliminary sample of 1981 tax returns taken by the Department of Treasury, producers of optical, App. G—Tax Policy and Research and Development on Medical Devices © 203 medical, and ophthalmic goods claimed R&D credits equal to 5.4 percent of total eligible R&D spending, while the corresponding figure for producers of other electrical equipment, including manufacturers of elec- tronic medical devices, was approximately 3.5 percent (418). These percentages may be compared with the percentage for all of the manufacturing firms sampled, which was 4.8 percent. Results reported by Eisner and colleagues for 1981, based on data in the Compustat tapes, are qualitatively consistent with these estimates. Specifically, Eisner and colleagues calculate that firms in the NSF industry group “optical, surgical, and other instruments” claimed R&D tax credits equal to 4.6 percent of eligible R&D, as compared with all manufacturing firms, which claimed R&D credits equal to 3.3 percent of eligible R&D (98a). However, their predictions for 1982 based on simulations indicate that producers of optical, sur- gical, and other instruments would be eligible to claim R&D credits equal to only 2.6 percent of qualifying R&D, as compared with all manufacturing firms, which would be able to claim credits equal to 2.8 per- cent of eligible R&D spending. The differences reflect differences among the sam- pled firms in the rate of growth in eligible R&D. How- ever, because the numbers pertain only to eligible R&D, they provide but a partial view of the relative impact of the R&D credit. The reason is that total R&D spending consists both of outlays for eligible R&D and outlays for R&D depreciable capital. Unfortunately, because R&D depreciable capital does not qualify for special tax treatment, firms are not required to report this component of R&D in their tax returns. Hence, it is difficult to estimate precisely the amount of R&D claimed as a percent of all R&D. A crude estimate of this latter magnitude may be obtained as follows. In the case of all manufacturing firms, it has been estimated that total company R&D spending equals roughly 2 percent of sales (423). How- ever, the total amount of eligible company R&D re- ported by manufacturing firms in the Treasury sam- ple equals only about 0.66 percent of the receipts reported by the firms (418). This figure suggests that eligible R&D spending equals roughly 33 percent of all R&D spending by firms in the sample. In this case, the amount of R&D credits claimed as a percentage of all R&D spending would be 1.6 percent (one-third of 4.8 percent). By comparison, NSF estimates that producers of op- tical, medical, and surgical instruments that perform R&D spend amounts on R&D which equal roughly 5 percent of sales (423). The total amount of eligible R&D reported by sampled producers of optical, med- ical, and ophthalmic goods equaled 0.8 percent of reported receipts. Thus, eligible R&D equaled roughly 16 percent of all R&D spending by this group of firms, so that the amount of R&D credits claimed as a per- centage of all R&D would be 0.9 percent. With the same procedure it is estimated that producers of other electrical equipment (including medical electronic devices) claimed credits equal to 0.5 percent of total eligible R&D. Thus, as a percentage total of R&D spending, the amount of R&D credit claimed by medical device pro- ducers may be less than that claimed by all manufac- turing firms. Of course, the industry classifications make it difficult to generalize about medical devices per se. The difference arises because eligible R&D may be a smaller share of total R&D among medical de- vice producers than it is among all manufacturing firms. Conclusion The analysis above suggests that the current tax sys- tem is generally favorable to R&D investments, but the incentives differ both among different types of in- novation and among different phases of the innova- tion process. With respect to medical devices, the limited data available suggest that R&D is relatively capital-intensive. Consequently, medical device R&D should benefit somewhat more than other industries’ R&D from the recent liberalization of tax depreciation allowances. However, to the extent that the innovative process in medical devices is more capital-intensive, the incentive effects of the incremental tax credit for R&D may be somewhat less for medical device pro- ducers than it is for firms whose R&D is more labor- intensive, because the special tax treatment of R&D does not apply to capital expenditures. Appendix H.—Consensus Standards Related to International Trade in Medical Devices! Introduction The ability to market medical devices effectively outside the United States depends partly on regulatory controls imposed by the U.S. and foreign governments and on standards or specifications set by local, na- tional, and international bodies. Most nations, in- cluding the United States, use regulations and prod- uct standards to control the sale of medical devices, both foreign and domestic. Although the need to pro- tect public health and safety provides justification for governmental regulation, governmentally imposed re- quirements relating to standards, certifications, inspec- tions and testing may create nontariff trade barriers. Standards based on one nation’s technology may by definition exclude foreign products. Testing and ap- proval procedures, developed and required for domes- tic use, may be conducted in such a way as to inor- dinately increase importers’ expenses. The internal orientation of certification systems may serve to limit access for imports or deny certification to imported products (379). These factors underscore the impor- tance of international cooperation and coordination in standards-related activities. The General Agreement on Tariffs and Trade (GATT) is the principal multilateral instrument that sets agreed rules for international trade. Its basic aim is to lib- eralize world trading practices through reduction of tariff and nontariff trade barriers. GATT, concluded in 1948 and currently subscribed to by 87 nations, pro- vides a continuing forum for multilateral discussions and negotiations on trade matters. In contrast to earlier rounds of negotiations which focused almost exclu- sively on tariff issues, the “Tokyo Round,” completed in 1979, focused on reducing or removing nontariff barriers to trade and resulted in six major agreements dealing with nontariff matters. One such agreement— The Agreement on Technical Barriers to Trade (or “Standards Code”)—is of particular importance to the medical devices industry and currently has more signatories than any other GATT code (see table H- 1). The Standards Code establishes international prin- ciples governing the development, adoption, or ap- plication of any standard or certification system by the signatories and thereby seeks to eliminate the use of standards and certification systems as nontariff trade barriers (379). Title IV of the Trade Agreements Act of 1979 (19 U.S.C. § 2501 et seq.) approved U.S. acceptance of the Standards Code and served to im- plement the code in the United States. "This appendix was drawn from a paper prepared for OTA by Lepon and Gawron (193). 204 This appendix explores how established interna- tional trade agreements (such as GATT) and Federal laws (such as the Trade Agreements Act) have affected trade in medical devices, specifically as they relate to the development and application of standards. This appendix also describes organizations and agencies in- volved in medical device standards-setting procedures, their procedures, the effect of implementing their standards, and U.S. Government responsibilities in standards-setting. Standards-Setting Organizations U.S. Voluntary Consensus Organizations Standards for medical devices in the United States have traditionally been developed in the private sec- tor by professional organizations, trade associations, and voluntary standards organizations. These volun- tary consensus standards are nonbinding standards de- veloped by consensus among voluntary participants such as consumers, manufacturers, professional asso- ciation representatives, physicians, clinical technicians, hospitals, and other users (117). Besides the organiza- tions described below, additional ones represent spe- cific interest groups such as hospitals, hospital sup- Table H-1.—Signatories to the Standards Code? Argentina Japan Austria Korea Belgium® LuxembourgP Brazil Netherlands® Canada New Zealand Chile Norway Czechoslovakia Pakistan Denmark? Philippines Egypt Romania European Economic Rwanda Community? Singapore Finland Spain FranceP Sweden Federal Republic of Switzerland Germany? Tunisia GreeceP United Kingdom? Hungary Hong Kong India United States Ireland® Yugoslavia Italy? 2As of Nov. 1, 1983. The Standards Code is adhered to by the European Economic Community, in addition to being adhered to by the 10 member states of the community. SOURCE: U.S. Executive Office of the President, Office of the U.S. Trade Representative, “Status of Tokyo Round MTN Agreement Signatures and Acceptances,” Nov. 1, 1983. App. H—Consensus Standards Related to International Trade in Medical Devices ¢ 205 pliers, health industry manufacturers, mechanical engineers, dentists, and pathologists (see table H-2). Some of these organizations develop standards for use by their own membership or have representatives on the boards and committees of other standards-setting organizations. American National Standards Institute, Inc. (ANSI). — ANSI is a private, nonprofit federation of standards- developing organizations and standards users. Founded in 1918, ANSI has been established over the years as the primary U.S. organization for sanctioning and ap- proving voluntary standards in many fields. ANSI ap- proves the American National Standards, a compila- tion of standards widely accepted by manufacturers, product purchasers, and other professional organiza- tions. ANSI has delegated the planning and coordi- nation of standards in the medical device field to its Medical Devices Standards Management Board, which is composed of representatives from professional so- cieties, trade associations, Government agencies, and general interest groups. Through this board, ANSI has approved nearly 200 standards for medical devices, primarily by accrediting the standards developed by other organizations. These standards include many for devices used for cardio- vascular surgery, neurosurgery, ophthalmology, or- thopedics, dentistry, anesthesiology, thoracic surgery, respiratory assistance, and in vitro diagnostic prod- Table H-2.— Additional U.S. Organizations Involved in Voluntary Standards Setting for Medical Devices American Academy of Allergy American Association for Clinical Chemistry American Association of Blood Banks American Association of Immunologists American Dental Association American Heart Association American Hospital Association American Institute for Ultrasound in Medicine American Psychiatric Association American Society for Artificial Internal Organs, Inc. American Society for Microbiology American Society of Mechanical Engineers American Thoracic Society College of American Pathologists Compressed Gas Association Health Industry Manufacturers Association Hearing Industries Association Illuminating Engineering Society Institute of Electrical and Electronics Engineers National Council on Radiation Protection and Measurements National Electrical Manufacturers Association National Sanitation Foundation Pharmaceutical Manufacturers Association Scientific Apparatus Makers Association SOURCE: J. Lepon and E. Gawron, Kornmeier, McCarthy, Lepon, and Harris, “Medical Device Standards and International Trade,” contract report prepared for the Office of Technology Assessment, 1983. ucts. ANSI also represents the United States in inter- national standards-setting bodies, most notably the In- ternational Electrotechnical Commission (IEC). ANSI coordinates standards to eliminate duplica- tion among those developed by different organiza- tions. In addition, it serves as a clearinghouse to pro- vide standards developers with information on the procedures and activities of other standards developers. Before a standard can receive the American National Standards designation, it must be reviewed by ANSI's appropriate committees. To this end, ANSI solicits comments from interested parties on the proposed standard in an effort to ensure that its due process re- quirements are met. If, as is sometimes the case, other recognized national standards already exist, ANSI will work to harmonize the standards so as to eliminate any overlap in content and ensure that a voluntary consensus can be achieved among the affected orga- nizations. Association for the Advancement of Medical In- strumentation (AAMI).—AAMI is a nonprofit, pro- fessional association formed in 1967 and comprised of individuals, hospitals, health care facilities, profes- sional and medical societies, Government agencies, manufacturers, and research and educational institu- tions concerned with the development, evaluation, and application of medical devices. Approximately 40 med- ical device standards, process guidelines, and recom- mended practices concerning such areas as critical care instrumentation are currently under development, and 11 are available in final form. AAMI carries out its work through technical committees composed of both medical device manufacturers and medical device users in an attempt to balance representation by the groups which will potentially be affected by any approved standards. AAMI participates in the international standards- setting activities of organizations like the International Organization for Standardization (ISO) and IEC through its membership in ANSI. At the request of ISO and IEC, AAMI has placed its members on their technical committees. For instance, an AAMI participant sits on ISO's technical subcommittee for cardiovascular im- plants and represents the view of AAMI members. American Society for Testing and Materials (ASTM). —ASTM, founded in 1898, is a nonprofit, nongovern- mental organization involved in developing voluntary consensus standards. In medical devices, its standards primarily, but not exclusively, relate to materials used to manufacture devices. ASTM has over 30,000 indi- vidual members representing Government agencies, private physicians, hospitals, public and private lab- oratories, and medical device manufacturers. ASTM standards provide guidance in determining the biocom- patibility of materials; define the properties and char- 206 e Federal Policies and the Medical Devices Industry acteristics of such materials as plastics, metals, and ceramics; and establish testing methods and recom- mended handling practices for medical and surgical in- struments. Nearly 30 technical committees are involved in reviewing and developing standards for medical sur- gical materials and devices. National Fire Protection Association (NFPA).— NFPA is an independent, voluntary, nonprofit orga- nization established in 1896 to protect people and their environment from destructive fires. NFPA’s member- ship is comprised of interested individuals and repre- sentatives of national trade and professional organi- zations. A primary function is the development of safety standards and codes that eventually become part of the National Fire Codes, a multivolume set of final, approved NFPA standards. In 1975, NFPA established a health care section to assist in the development of standards that may help to prevent fires in medical facilities. NFPA also en- courages safe use of medical devices, particularly elec- trically powered medical devices, in patient areas. It participates in many other standards-setting organi- zations by placing its members or organizational staff on their technical committees. For instance, NFPA is an active participant on ASTM's committee on the hazard potential of chemicals and ASTM'’s subcom- mittee on flammability and ignition testing, AAMI's subcommittees on electrical safety and monitoring devices, and the U.S. Veterans Administration (VA) Advisory Committee on structural safety of VA facil- ities. Through its membership in ANSI, NFPA also assists in the review and development of the Ameri- can National Standards and participates in the inter- national standards development activities of IEC. NFPA standards for safety have been widely ac- cepted by States and local governments in establish- ing regulations for licensing of medical facilities and for regular building inspections. Although NFPA stand- ards are voluntary, their adoption by the regulatory agencies of State and local governments have made some of them mandatory. National Committee on Clinical Laboratory Stand- ards (NCCLS).—NCCLS is a private, nonprofit cor- poration devoted to upgrading health care by improv- ing the quality of clinical laboratory methods and by providing acceptable guidelines and standards for clin- ical laboratories. NCCLS was founded in 1968 by rep- resentatives of the clinical laboratory services profes- sions, the Federal and State Government agencies with responsibilities for public health, and diagnostic prod- ucts companies that provide the reagents, instruments, and systems used in clinical laboratory identification and measurement. Its members work to produce volun- tary consensus standards through numerous technical committees. NCCLS coordinates the process by which national consensus on clinical laboratory standards is achieved, and thus expedites the process by which NCCLS stand- ards become adopted as national and international standards. It works closely with its European counter- part, the European Committee on Clinical Laboratory Standards, as well as with the International Organiza- tion of Legal Metrology, and ISO in developing and harmonizing international standards. Underwriters Laboratories, Inc. (UL)—UL is an in- dependent not-for-profit corporation established in 1894 to help reduce or prevent bodily injury, loss of life, and property damage. UL has developed stand- ards and requirements covering medical and dental equipment intended for professional use by personnel in hospitals, nursing homes, medical care centers, med- ical and dental offices, and other health care facilities. UL'’s standards for safety are based on research and cooperation by engineers, manufacturers, consumers, and recognized specialists in many fields. Many UL standards for safety are recognized as American Na- tional Standards by ANSI. UL is a member of ANSI and assists in the review and development of Ameri- can National Standards. Its staff members serve on technical committees and subcommittees of various domestic standards developing organizations such as ASTM and NFPA, as well as international organiza- tions such as IEC and ISO. UL standards and requirements are the basis on which UL’s registered certification mark may be affixed to complying products by subscribers to UL’s services. This system of marking is recognized by consumers, regulatory authorities, and others who seek and rely on third-party certification of products with respect to safety. Federal, State, and municipal authorities, ar- chitects, building owners, and consumers may require listing or classification by UL as a condition of their acceptance of a device, system, or material having a bearing upon risk of fire, shock, or other injury to per- sons or property. Although UL standards for safety are voluntary, adoption by regulatory agencies has made some of them mandatory (109). International Organizations International Organization for Standardization (ISO).—ISO, formed in 1947, is an organization of na- tional standards institutes involving over 84 countries. Its objective is to promote development of worldwide standards for the purpose of “facilitating international exchange of goods and services and to develop mutual cooperation in intellectual, scientific, technological, and economic ability” (169). ISO recognizes ANSI as the representative member body for the United States. Other U.S. standards- App. H—Consensus Standards Related to International Trade in Medical Devices ¢ 207 setting organizations, including various Federal Gov- ernment agencies and representatives of manufac- turers, participate in many of ISO's technical commit- tees that are concerned with medical devices. These groups together comprise the U.S. delegation to the international organization. Members participate on such technical committees as dentistry, implants for surgery, mechanical contraceptives, prosthetics, and transfusion equipment. The development of international standards, of which there are nearly 200 relating to medical devices, is a slow, deliberative process. First, draft proposals are submitted by interested national standards orga- nizations or individuals to technical committees for study. Most of the work of reviewing these proposals is done through correspondence with its members. The process of approving a standard may take as long as 6 or 7 years, but most proposed standards take about 3 years to gain approval as an International Standard. Once a standard has become an International Stand- ard, many national standards institutes and govern- ments often seek to adopt it as their national stand- ard as well. For example, ANSI, working through its American Dental Association members, has adopted the ISO standard for dental zinc silico-phosphate as an ANSI standard (ANSI/ADA 21-1981). The reverse case has also occurred, in which a specific national or regional standard has become an International Stand- ard. This situation is becoming more common as many aggressive national and regional standards organiza- tions attempt to have their own standards accepted in- ternationally. For example, AAMI has introduced its draft standard for implantable ventricular pacemakers (AAMI IP) to ISO, which in turn accepted it as a draft International Standard (ISO 5841.1). International Electrotechnical Commission (IEC). — IEC was formed in 1906. In accordance with a formal agreement between IEC and ISO, questions related to international standardization in the electrical and elec- tronic engineering fields are reserved to IEC and other subject areas are the responsibility of 1SO. If ISO undertakes an international standardization matter unrelated to a particular technology, it consults IEC to safeguard any electrotechnical interests that may be involved. The structure and process of standards development by IEC is similar to the methods employed by ISO. The recognized national standards institutes with responsibility for development of standards for elec- trical products are IEC members. ANSI’s U.S. National Committee is the U.S. member of IEC, and other U.S. voluntary consensus organizations may participate in IEC’s standards development process through its tech- nical committees (169). Other International Standards-Setting Organiza- tions.—The organizations with specific areas of inter- est contribute their expertise to the development of those standards. Many of these international volun- tary organizations maintain close liaison with their na- tional counterparts in the United States. The govern- mental role in these associations is limited to the extent that an individual member of a national professional society may also be a government employee and as such have contact with her or his international counterparts in the exchange of information. The International Committee for Standardization in Hematology develops reference materials and recom- mends standardized techniques in diagnostic hematol- ogy, blood transfusion practices, and related activities. The International Union of Immunological Societies and the International Federation of Clinical Chemists develop specifications for methods of testing and materials and also receive and organize international tests to submit to the World Health Organization (WHO) for acceptance as recommended procedures. WHO also develops and promotes standards in medi- cal devices. Expert panels and committees of WHO have worked on such topics as standardization of diag- nostic equipment and quality control in health labora- tories. The International Organization for Legal Metrology (OIML) is a treaty body established in the early 1950s. It is comprised of 48 countries, including the United States, which joined in 1972. OIML works to har- monize international standards for legal measuring devices, such as gasoline pumps and weight scales, and, in the medical field, such devices as blood pres- sure gauges and electrocardiographs. The National Bu- reau of Standards represents the United States in OIML. A U.S. advisory committee for legal metrol- ogy—consisting of representatives of Government agencies concerned with legal measurements, manu- facturers of measuring devices, and major standards organizations such as ASTM and ANSI—provides guidance to the National Bureau of Standards when it represents U.S. interests in OIML. Many international and regional trade associations participate in developing their own standards, and contribute to organizations such as ISO and IEC. Some of these associations represent manufacturers of radi- ation equipment, surgical instruments, and clinical lab- oratory materials. European Standards-Setting Organizations Because of the large number of countries in Europe, with their varied political, social, and economic sys- tems, the environment is a “complex scenario against 208 ¢ Federal Policies and the Medical Devices Industry which to review standards and regulations applying to health care” (73). In addition to the government- affiliated and independent standards institutes within the various countries, there are also regional standards- related organizations. The membership of the European Committee for Clinical Laboratory Standards represents health agen- cies, professional societies, and industry. Its objective is to improve clinical laboratory practices through a voluntary consensus mechanism (386). The European Committee for Standardization (CEN) is composed of the national standards organizations of countries in the European Common Market, plus Austria, Finland, Norway, Portugal, Spain, Sweden, and Switzerland. Its major objective is to harmonize Western European implementation of ISO and IEC standards. In addition, it has developed approximately 60 “European Standards” in nonelectrotechnical fields. CEN operates certification systems, usually with re- spect to European Standards, and systems for recogni- tion for test results for national certification programs where no European Standards exist (9). The European Committee for Electrotechnical Stand- ardization (CENELEC) is comprised of the national electrotechnical committees of its member countries. CENELEC seeks to harmonize the national electro- technical standards of its member countries and uses IEC publications as a basis for its activities. Its major objective is to eliminate, through mutual agreement, any technical differences between the national stand- ards and certification programs of its members that would result in trade barriers. In addition to its har- monization activities, CENELEC also develops Euro- pean Standards in the electrotechnical field (9). In general, each country has a national standards institute that produces or sanctions standards, much as does ANSI. These institutes also have technical com- mittees comprised of government officials, manufac- turers, and end-product users. For the most part, standards established by these institutes are voluntary; however, since each country has its own method of administering and monitoring compliance with these standards, the line between voluntary standards and mandatory regulations is often blurred (73). Therefore, it is useful to describe briefly key aspects of the stand- ards setting and administering processes for several major European nations, namely the Federal Republic of Germany, the United Kingdom, and France. In 1981, a group of international medical device manufacturers? formed the European Regulatory- 2Becton-Dickinson-France, S. A.; Beiersdorf A. G.; Cordis Dow, B. V_; Johnson & Johnson, Ltd.; Medtronic France, S. A.; Miles Laboratories, Ltd.; 3M Europe, S. A.; Travenol International Services, Inc.; and Welcome Reagents, Ltd. Technical Affairs Study Committee, and conducted a study in the major nations of Europe on the state of regulatory affairs in the field of medical devices, in- cluding the diagnostic field. The resulting six-volume report contains a listing of government regulatory agencies, as well as information on certifying and testing organizations and on national standards-set- ting. This report indicates that there is an increasing trend for development of standards in Europe (102). Federal Republic of Germany.—Two national laws govern most of the Federal Republic of Germany's gov- ernmental involvement in standards-related activity: the Drug Law of August 24, 1976; and the Law on Technical Equipment and Devices of June 24, 1968, as amended August 13, 1979 (163). Although the Drug Law is directed primarily to the pharmaceutical indus- try, it defines “drugs” to include certain surgical dress- ings, surgical sutures, and diagnostic products within the term “fictitious drugs” (164,174). In addition, im- plantables are brought within the scope of the legisla- tion once they are actually implanted (163). The Drug Law is comprehensive and contains sec- tions on manufacture, licensing and registration, clin- ical trials, recording of adverse effects, inspections, labeling, and advertising (174). The Ministry of Health has statutory responsibility when problems with reg- ulated products are reported and corrective action is necessary (163). The Technical Equipment and Devices Law, ad- ministered by the Ministry for Labor and Social Af- fairs, sets forth standards for equipment safety. Special provisions require that a manufacturer certify that technical medical equipment is in proper condition and that either the manufacturer or an officially designated expert has subjected the equipment to final inspection. Equipment controls and operating instructions must incorporate use of the German language or utilize standard symbols (164). There are two principal standards-setting organiza- tions in West Germany. The Verband Deutscher Elektrotechniker (VDE) develops standards and pro- vides certification testing and listing services for elec- trical components and systems. The other, the Deutsches Institut fiir Normung (DIN), is a voluntary consen- sus standards organization that has developed stand- ards in a number of areas. Standards involving elec- trical aspects are often published jointly by DIN and VDE. In addition, there is a major testing-certification organization called the Technischer Uberwachungs Verein (TUV) which deals primarily with complete products, rather than their component parts. TUV issues a “GS” (Gepriifte Sicherheit) mark that, al- though not mandatory, carries with it the same sort of prestige as the UL mark in the United States (293, 135). App. H—Consensus Standards Related to International Trade in Medical Devices © 209 United Kingdom. —In the United Kingdom, with its national health system, the Government is the primary user of medical devices. The Medicines Act of 1968 requires full premarket evaluation for drugs and medi- cines and sets forth requirements for licensing, manu- facturing, inspecting, testing, and labeling. Certain medical devices, such as surgical sutures, dental fill- ing substances, contact lenses, intrauterine contracep- tive devices, and certain radioactive medicinal prod- ucts, have been brought within the regulatory framework of the Medicines Act (174). The British Standards Institution (BSI) is a volun- tary standards-setting organization that was formed in 1901. In addition to its standards-developing activ- ities, BSI also provides testing and certification serv- ices. Although the standards developed by BSI are voluntary, the Department of Health and Social Secu- rity (DHSS) has issued a recommendation that gov- ernmental purchases of medical devices comply with existing BSI standards (149). Therefore, medical de- vices manufacturers regard BSI standards as man- datory in practice, as they must be met in order to mar- ket devices effectively in the United Kingdom. As BSI standards cover only a relatively small num- ber of medical devices, DHSS general specifications, technical requirements, and voluntary “good manu- facturing practices” have been developed to fill this void. Through its Scientific and Technical Services Branch, DHSS has also established a registration scheme for manufacturers. The role of that branch is to de- velop, in conjunction with various trade associations, suitable standards for quality assurance or good man- ufacturing practices, to assess the manufacturers’ com- pliance with those general standards, and to publish a register of manufacturers complying with the good manufacturing practices (149). In the event that this voluntary scheme proves ineffective, the Medicines Act provides for residual authority to extend its scope to cover all medical devices (163). France.—In France, the authority to control medi- cal devices is derived from the Ministry of Health and Family and the Ministry of Industry. The two major mechanisms for control are the French Pharmacopeia and a “homologation” system (a system of official ap- proval) (174). The Ministry of Health and Family publishes Phar- macopeia monographs that contain specifications and descriptions for many sterile products, a variety of plastic products, surgical dressings, sutures, various tubing, and absorbent cotton. Requirements dictated by the Pharmacopeia are technically applicable only to products sold to public institutions (which account for over 90 percent of all medical facilities in France) or to products that claim to conform to the Phar- macopeia (164,293). The homologation system is a process of obtaining official government approval applicable to a listing of devices that is periodically reviewed and updated. Al- though approval is mandatory only for products pur- chased by public institutions, the homologation sys- tem is linked to reimbursement procedures under the French social security system. Therefore, approval is necessary whenever a purchaser wishes to apply for reimbursement (164). Until recently, approval had been granted by an interdepartmental commission, and product-specific requirements, specifications, and pro- cedures for testing were stipulated by decree. In January 1983, France introduced an entirely new scheme of approval. Although it is unclear how the new scheme will operate in practice, the interdepart- mental commission has been abolished, and a National Committee of Homologation, which has full respon- sibility for the approval process, has been created within the Ministry of Health and Family. The Na- tional Committee has five subcommittees, composed of experts drawn from the ministries, hospitals, and universities, and charged with defining the homologa- tion procedures. The subcommittees operate in the areas of: imaging, operating theaters, artificial organs and prostheses, anesthesia and reanimation, and diag- nostic equipment and monitoring (163). In general, approval requests must be presented to the Ministry of Health and Family by an authorized agent established in France, and a testing laboratory will then be assigned. In practice, only laboratories within the Groupment des Laboratoires des Materiels de Technique Medicale are adequately equipped and staffed to do the work. For an electrically powered product, the French Electrical Code is applied as the minimum standard. If a particular product standard exists, it is also applied. Clinical testing may be re- quired by physicians assigned by the ministry (293). The Association Francaise de Normalisation (AFNOR) is France's primary standards organization. AFNOR is a private, public service association that centralizes and coordinates all work and studies concerning stand- ardization, much as does ANSI. Formed in 1926, AFNOR is a voluntary organization of manufacturers, consumers, professional associations, and government representatives. Standards developed by AFNOR are voluntary; however, they may become mandatory if adopted for use within the homologation system. In 1943, AFNOR was given governmental authority to develop public standards and to administer the mark “NF” as indicating conformity with a standard. Other Foreign Organizations Japan.—The Ministry of Health and Welfare regu- lates the importation and sale of medical devices pur- 210 e Federal Policies and the Medical Devices Industry suant to the Pharmaceutical Affairs Law. In July 1983, an omnibus bill was passed making extensive changes in Japan's standards and certification system. The om- nibus bill is the culmination of over 4 years of bilateral discussions between the United States and Japan (121). Standards in Japan are normally developed through advisory committees to Japanese Government minis- tries (359). The Japanese Industrial Standards Com- mittee (JIS) within the Ministry of International Trade and Industry is of particular importance to the medi- cal devices industry. Products conforming to JIS stand- ards and testing requirements are entitled to bear the “JIS” mark, which is the most prominent and widely used certification mark in Japan. Prior to passage of the recent amendments, only JIS standardized medical devices were exempt from the ap- proval process. The new legislation permits certain non-JIS standardized devices to bypass the approval process. The devices exempted are those for which the utility, efficiency, and safety is generally acknowl- edged, including such items as surgical knives, tweezers, medical scissors, sterilizers, operating tables, and stethoscopes (121). Canada.—In Canada, the Department of National Health and Welfare’s Bureau of Medical Devices (BMD) is the central point for mandatory standards. Under the Food and Drug Act of 1953, the department was granted authority to adopt standards and create reg- ulations for medical devices. To date, BMD, which was created in 1975, has developed seven medical de- vice regulations: 1) contraceptives, 2) cardiovascular pacemakers, 3) hearing aids (revoked in 1979, but the bureau is working to have them reestablished), 4) mobile oxygen inhalators, 5) blood collection tubes, 6) disposable insulin syringes, and 7) electromedical devices. In developing these standards, BMD exam- ined existing national voluntary standards and other international and foreign standards which could be adopted or modified, and then based its standards upon a synthesis of them. The Canadian Standards Association (CSA) is a voluntary, nonprofit, autonomous organization that provides standards-writing and certification services. Its members are drawn from the industrial, govern- mental, private, and educational sectors. In the mid- 1970s, CSA initiated a Health Care Technology Pro- gram, whose goal is to develop consensus standards in the medical engineering field and to implement those standards throughout Canada through education, pro- fessional societies, and provincial or federal legislation (90). CSA is also a testing house for certification of medical devices. Manufacturers can pay to have their products certified as complying with CSA standards and certain other relevant standards. The majority of Canadian medical device standards are not mandatory. However, since almost all of Can- ada'’s hospitals are public, various provincial govern- ments require that certain medical devices meet CSA's standards or some other national, international, or foreign standard, such as those of AAMI or ISO. This requirement has the effect of making many voluntary standards mandatory in operation. For ex- ample, all electromedical equipment sold or used in any Canadian province must be “approved,” which in effect means that the product must be shown to con- form to CSA standard C.22.2 No. 125 (90). Although certain CSA standards are substantially similar to UL standards in the United States, CSA does not auto- matically certify products certified by UL, but conducts its own testing (463). Like ANSI (the American National Standards Insti- tute), the Standards Council of Canada, a nonprofit organization, coordinates other standards-setting orga- nizations and sanctions the standards developed by these bodies. Mexico.—The Mexican Government has no uniform system of standards development that affects medical devices (301). The importation of medical products is governed only by the customs law and not by medi- cal device or pharmaceutical legislation as in other de- veloped countries. Entry requires a certificate of origin and description of the product. If a product bears a certification of compliance with the standards of the producing country, such as a UL mark, this certifica- tion is generally accepted by customs officials. Change in the enforcement of customs laws in Mex- ico can generally be traced to national and interna- tional economic policy issues, such as the effect of im- ports on Mexican employment and other such economic concerns. These reasons usually are not directed at control of the quality, safety, or effectiveness of the products (301). U.S. Government Agencies Involved in Standards-Setting Related to International Trade The GATT Standards Code establishes new inter- national ground rules in the area of technical (non- tariff) barriers to trade. It sets forth international rules among governments for regulating the procedures by which standards and certification systems are pre- pared, adopted, and applied and by which products are tested for conformity with standards (359,380). The basic premise of the code is that standards-related activities should not be used as mechanisms to restrict unnecessarily international trade (46). App. H—Consensus Standards Related to International Trade in Medical Devices ¢ 211 Although the code is directly binding only on the central governments of its signatories, these govern- ments are obliged to take reasonable measures to en- sure that regional, State, local, and private organiza- tions also comply with the code’s provisions (359). Therefore, the code provisions affect governmental and nongovernmental standards, whether voluntary or mandatory, and whether developed by central, re- gional, State, or local governments or private sector standards organizations. Three U.S. Government agencies play a significant role in the implementation of the Standards Code in the United States: the Office of the U.S. Trade Repre- sentative, the Department of Commerce, and the De- partment of Agriculture (380). The Department of Agriculture's role, while important with respect to overall implementation of the code, is beyond the scope of this paper. Activities within the Department of Health and Human Services are outlined below. U.S. Department of Health and Human Services The National Center for Devices and Radiological Health in the Food and Drug Administration (FDA) frequently interacts with domestic and international voluntary standards-setting organizations. Domes- tically, the national center contributes to the review and development of standards by organizations such as ANSI, AAMI and ASTM.? FDA also participates in development of international standards through its work on the technical committees of both ISO and IEC. However, U.S. Government agencies have nei- ther control over nor any official leadership role in the domestic or international private voluntary standards- setting process. Recently, U.S. Government agencies—specifically FDA —have increased their participation in voluntary standards-setting activities because of two Federal pol- icy initiatives: the GATT Standards Code, as imple- mented in the Trade Agreements Act of 1979 (19 U.S.C. §§ 2531-2573) and Office of Management and Budget (OMB) Circular A-119. Both of these policy initiatives establish guidelines for and encourage Fed- eral Government agency participation in domestic and international voluntary standards-setting activities. The Trade Agreements Act recommends the use, where appropriate, of international standards as the basis for developing domestic standards. FDA's work with voluntary organizations is important, therefore, to ensure that the U.S. view is expressed and that in- ternationally developed standards are consistent with 3FDA's activities regarding mandatory performance standards are discussed in ch. 5. U.S. national standards in terms of product safety and effectiveness. OMB Circular A-119 sets forth as Federal policy that the U.S. Government will rely on voluntary standards, both domestic and international, where appropriate, in lieu of governmentally developed standards. Cir- cular A-119 also specifies that Federal employee par- ticipation should not in any way attempt to dominate the voluntary process (21). The Centers for Disease Control (CDC) has also been active in voluntary standards-setting activities in the medical devices field. CDC provides technical assistance to organizations such as the National Com- mittee on Clinical Laboratory Studies through CDC's work with various professional societies and through information received from State health departments and other public and private medical laboratories. Office of the U.S. Trade Representative In connection with its responsibility for setting and administering overall trade policy, the U.S. Trade Rep- resentative (USTR) coordinates the development and execution of the U.S. standards-related trade policy (419). USTR is responsible for resolving standards- related trade disputes between the U.S. and foreign governments, overseeing the general implementation of the Standards Code in the United States and coordi- nating the international trade activities of other U.S. Government agencies that engage in standards-related activities that may significantly affect trade, and ne- gotiating bilateral standards arrangements (380). Under the Standards Code, any signatory may ques- tion another signatory’s compliance with code provi- sions. Bilateral or multilateral consultations are en- couraged to resolve disputes. In the United States, a private party may informally raise with USTR a for- eign practice that appears to be inconsistent with the code or otherwise denies benefits to the United States under the code (380). USTR will then pursue the resolution of problems, keeping the complaintant ap- prised of its activities. Problems arising under the code usually involve: failure by signatories to provide ade- quate information on their standards-setting activities, failure by importing governments to adopt standards set by international organizations, nonacceptance by importing countries of test data generated in the United States, and denial of access to certification systems (359). U.S. Department of Commerce National Bureau of Standards (NBS).—NBS has been delegated the responsibility for establishing and 212 e Federal Policies and the Medical Devices Industry maintaining the U.S. inquiry point for Standards Code matters, the central repository for standards and cer- tification information, and a technical office for non- agricultural products. The responsibilities delegated to NBS are carried out through the Office of Product Standards Policy's Standards Code and Information program. As the U.S. inquiry point mandated by the Stand- ards Code, staff of the Standards Code and Informa- tion program notify the GATT Secretariat of proposed U.S. regulations potentially having an effect on trade. They receive notices and information on proposed foreign regulations and disseminate the information through several media and directly to interested U.S. parties. A primary objective of the notification pro- gram is to encourage review and comment on pro- posed foreign regulations. Foreign notifications are routed through various Government agencies, such as the Bureau of Industrial Economics in the Department of Commerce (DOC); agency members of the Inter- agency Committee on Standards Policy; private stand- ards organizations; and industry groups. This program also operates the National Center for Standards and Certification Information, which is the national repository for standards documents. The cen- ter responds to general inquiries about the existence of specific standards and regulations and maintains a reference collection of voluntary and mandatory U.S. standards, as well as major foreign and international ones. The technical office within the program provides assistance in the areas of exchange of information and dispute settlement. To market products in foreign countries, U.S. ex- porters must be informed of the testing procedures, approval programs, and certification rules in effect in those countries. To date, there are no centralized or accessible reference collections that can provide ex- porters with this essential information (359). Current funding and staff resources within the Standards Code and Information program are insufficient to allow it to expand effectively into this area (1,91). However, the center has begun to collect certification informa- tion on an informal basis through its collection of materials on foreign and international standards activ- ities and through information provided by U.S. trade and professional organizations. International Trade Administration (ITA).—The Trade Agreements Act directs the USTR and the Sec- retaries of Commerce and Agriculture to consult with the private sector for technical and policy advice on the implementation of the Trade Agreements Act and the Standards Code (46,359). In order to meet its responsibilities, DOC has established an Industry Functional Advisory Committee (IFAC) on Standards for Trade and Policy Matters. IFAC, administered by ITA in DOC, is composed of approximately 20 mem- bers drawn from Industry Sector Advisory Commit- tees within DOC and an approximately equal num- ber drawn from private sector groups involved in standards-related activities (359). IFAC is responsible for advising USTR on matters concerning trade, the operation of existing trade agree- ments, and other matters connected with U.S. trade policy. IFAC provides detailed policy and technical ad- vice, information, and recommendations concerning standards and their effect on trade and the implemen- tation of the Standards Code (359). Although the mandates of the Standards Code are technically applicable only to the Federal Government, the Trade Agreements Act legislation calls on the Presi- dent to promote adherence to the code principles by State and private sector bodies (19 U.S.C. § 2533). To this end, ITA has issued voluntary procedural guide- lines for State and local governments and private sec- tor organizations engaged in standards development, product testing, and certification systems (314). Representation of U.S. Interests in International Standards Organizations.—The Trade Agreements Act directs the U.S. Secretaries of Commerce and Agri- culture to keep adequately informed of international standards-related activities, to identify those activities that may have a substantial effect on U.S. commerce, and to coordinate those efforts with USTR. Although the act does not designate any specific private orga- nization as the “official” representative of U.S. inter- ests, it confirms the role of U.S. member bodies in pri- vate international standards organizations, such as the ANSI/ISO relationship. The Secretary of Commerce has authority to deter- mine that a member body is not adequately represent- ing U.S. interests and to make arrangements for ade- quate representation (380). For any governmental international standards organizations in which U.S. interests are represented by one or more Federal agen- cies, the Secretary is directed to encourage coopera- tion among the agencies to seek a uniform position. In addition, the Secretary is directed to encourage such Federal agencies to seek information from and coop- erate with any affected domestic industries (380). The Standards Code and Information program fulfills DOC'’s obligations with respect to ensuring adequate representation of U.S. interests in international stand- ards-setting through two major activities. First, the program's technical office responds to any informa- tion, complaints, or criticisms concerning participa- tion in international standardization activities. Second, the program maintains statistics and information on U.S. participants in international standards-related activities (359). App. H—Consensus Standards Related to International Trade in Medical Devices ¢ 213 Problem Areas for Medical Devices Standards in International Trade At an OTA workshop in August 1983, representa- tives of selected members of the Health Industry Man- ufacturers’ Association (HIMA) identified certain prob- lems related to standards and international trade. All the participants came from large companies that engage in foreign trade. Although their views may not be generalizable to the medical devices industry as a whole, they do indicate the experiences and perspec- tives of companies from several areas of medical de- vices (see app. B for a list of workshop participants). It should also be borne in mind that a complete exam- ination of standards-setting would require considera- tion of the benefits to purchasers and users of devices. This section discusses issues raised at the workshop as well as information from Government agencies and other industry representatives. Development of Standards Rationale or Need for Standards. —Workshop par- ticipants commented that insufficient attention is given to the rationale for developing standards. Developing medical device standards may proceed with little or no demonstration of concerns related to clinical safety and effectiveness (118). For safety standards that are engineering- or technology-based, much time and ef- fort may go into creating standards important from an engineering point of view but of limited concern from a medical point of view. One way to demonstrate that a standard is reasonable is to include a rationale that defines the standard’s purpose and limitations (118). A related comment was that many standards are de- veloped without any attempt to examine costs and benefits. Highly restrictive, costly, hardware-oriented standards are produced where adequate nonhardware alternatives (such as education, training, and preven- tive maintenance) for resolving the problem may ex- ist. Publication of a rationale would facilitate public review and comment and would permit more appro- priate application of standards (89). The workshop participants advocated greater clin- ical input into standards development. Recently, a trend to involve medical professionals has been devel- oping, particularly in the United States and in Can- ada, but many medical professionals appear reluctant to take the time away from their practices (or other responsibilities) or incur the expenses connected with participation. Consequently, standards may contain requirements that differ from those necessary to assure the safety and effectiveness of medical devices (145). ) There was speculation that some foreign countries have reacted to the 1976 Medical Device Amendments by promulgating their own standards, both voluntary and mandatory. The question was raised of whether or not standards are needed, considering that many manufacturers produce devices to specific internal cor- porate standards based on current scientific and tech- nical information, the marketability of the devices, and protection of the company from personal injury liability. Access to Information.—When standards—domestic, foreign, and international—are being developed, it is often difficult for an individual or company to gain timely access to information so that comments can be submitted. A major objective of the Standards Code is to make standards-setting and certification activi- ties open to all interested parties, and code signatories must follow certain procedures for new or amended mandatory standards and certification system rules (380). However, few foreign countries have detailed specific requirements regarding public notice, and the Standards Code requirements speak only in terms of reasonableness. Although none of the code signatories maintain notice procedures that actually violate the code, U.S. manufacturers have encountered difficulties in obtaining the timely, adequate information neces- sary for making meaningful comments (359). FDA's notices of proposed standards development may not give enough information about the purpose or rationale to determine the scope or need for com- ments (21 CFR pt. 866). At the local level, users of standards, manufacturers, or consumers are not all members of national organizations and do not all subscribe to the publications (such as the Federal Reg- ister for domestic notices and the Commerce Business Daily for foreign notices) in which notices are pub- lished. Consequently, they may not take part in the comment process. In January 1980, HIMA surveyed its membership to obtain information regarding members’ interna- tional marketing activities, monitoring of regulations and product standards, and participation in foreign in- dustry organizations. According to the survey results, manufacturers typically rely on foreign agents and distributors for information on changes in foreign reg- ulations and product standards, and many have des- ignated a specific employee, stationed either in the United States or abroad, to monitor standards-related developments. Whereas over 70 percent of the manufacturers re- sponding to the survey relied on distributors, agents, and employees as information sources, 35 percent of the respondents obtained information directly from U.S. Government sources and 21 percent obtained the 214 e Federal Policies and the Medical Devices Industry information directly from foreign governments or foreign industry organizations (146). Some European countries with only a few manufac- turers in specialized fields such as medical devices have developed standards swiftly. These standards are often based on locally manufactured products and may, in fact, serve to restrain import trade. The standards- setting government may justify its standards by assert- ing that they are based on international standards “with qualifications,” but the qualifications may be substantial and belie the original standard. Because these standards are often quickly enacted, U.S. stand- ards organizations and interested manufacturers often have difficulty submitting comments in a timely man- ner. Once these standards are finalized, U.S. manu- facturers may have difficulty in having their products conform to the foreign standards. Suitable Representation.—The expense of analyz- ing drafts, preparing comments, and attending inter- national meetings often makes it particularly difficult for small companies to participate, since the cost of participation is the burden of the individual commit- tee members. In the private sector, it is usually the manufacturer who pays the expenses of the employee representative. The review and comment work of com- mittees usually takes place over a period of months, or years in some cases. As a result, the interests of small manufacturers (and others unable to attend in- ternational meetings) in international standards-setting are often not taken into account. Although 98 percent of the manufacturers respond- ing to the HIMA survey were involved in the export or foreign manufacture of medical products, only 27 percent indicated membership in foreign industry orga- nizations and only 25 percent reported active direct involvement in international standards organizations. The manufacturers that did participate in international standards development reported employee participa- tion in various technical committees of organizations such as IEC, ISO, NCCLS, and OIML—as well as the national standards organizations of Australia, France, West Germany, and the United Kingdom (146). Even with improved representation in international standards setting, U.S. interests may be unable to in- fluence decisionmaking at the international level. Euro- pean countries involved in the regional standards setting activities of organizations such as CEN and CENELEC often vote as a bloc in ISO or IEC to estab- lish European technology as the basis for international standards (249). Application of Standards Cost of Conforming to Standards.—In the United States, UL or NFPA standards are often specified in public municipal codes, such as building and safety codes, or in purchasing specifications. Products must then bear a UL mark or other form of approval to be used within those jurisdictions. A device may be subject to design and performance standards as well as installation and use standards. Each time a test is conducted, additional costs are incurred. For exam- ple, some electrical devices require a UL mark as well as conformity to NFPA fire and safety codes. In addi- tion, a foreign government might require different or additional tests and markings for the same product. Although manufacturers consider some medical de- vices standards, such as those developed under the 1968 Radiation Control for Health and Safety Act, to have significantly improved the safety and quality of the products, they also maintain that the improve- ments have raised the cost of research, development, and final products. In foreign countries, the cost to a U.S. manufacturer of complying with foreign standards that differ from domestic standards must be built into the price of its products. This can make U.S. products more expen- sive than local foreign ones, and thus less cost com- petitive. To minimize the costs of additional testing or procedures related to meeting foreign and domes- tic standards, as well as for other reasons, U.S. man- ufacturers have set up overseas operations. Establish- ment of foreign manufacturing subsidiaries by U.S. companies diminishes the balance-of-trade advantage for the United States. Interpretation and Reliability of Information.—The existence of an international or foreign standard, and knowledge of its existence by a U.S. manufacturer, has only limited value. It is more important to the manu- facturer to know how that standard will be interpreted by local or national officials, or other certifying bodies such as testing laboratories, government reimburse- ment agencies, or insurance providers. In the Federal Republic of Germany, for example, there are DIN standards for medical device compo- nents, but within the country the officials of the vari- ous states interpret these standards differently. Differ- ing interpretations can result in costly delays in supplying products or in cancellations of orders and contracts. In Germany, U.S. importers also face problems re- lating to insurance coverage. For example, although not legally required, a customer's insurance carrier asked the importer of an ultrasound imaging device to certify that the product met radiofrequency in- terference standards (235). This action caused consid- erable expense to the manufacturer in legal fees and delayed introduction of the product. This situation occurs in other countries as well where the ultimate legal responsibility for radiofrequency in- terference (or any other responsibility for equipment App. H—Consensus Standards Related to International Trade in Medical Devices ¢ 215 safety or performance) rests with the user as opposed to the manufacturer. In order to obtain insurance cov- erage in these situations, the user's case is much stronger if it can be shown that the product meets, or has been certified to, the requirements of an applicable stand- ard (293). Most companies doing business internationally must rely on their market researchers to identify standards or other requirements that they must meet or on local distribution agents for their knowledge of local admin- istrative procedures. Obtaining information through these sources is costly and time-consuming. It is all the more difficult for those companies that cannot afford researchers or local agents. Once manufacturers have obtained information re- garding foreign standards-related practices, they often encounter difficulties in confirming the accuracy of that information and determining its practical impli- cations. A major difficulty in foreign standardization activities is determining what is required versus what is customary or desirable in certain markets. Manu- facturers report that certain foreign standards re- quirements that appear to be mandatory may in prac- tice be negotiable with the inspector. For example, in the United Kingdom, one manufac- turer succeeded in overcoming a seemingly mandatory DHSS radiation protection standard for X-ray equip- ment that contained an unworkable limit on fluo- roscopic exposure. Through negotiations with the in- spector involved, the manufacturer was able to obtain approval of its product (235). Effect of Standards on Innovation.—The interpreta- tion of standards by foreign governments and the reliability of information can be linked to the issue of how standards keep pace with new technologies. Some countries, such as Mexico, reportedly use out-of-date standards and have rejected products not meeting these standards. A recent example involved implantable pacemakers (301). Although some standards have provisions for assess- ing new or improved products, others are written to preclude newly developed or improved products, such as the replacement of digital monitors for analog equipment. If standards are not written to accom- modate product changes, introduction of new technol- ogies will be restricted by existing standards and will serve as a barrier to trade. The process of changing standards, especially inter- national standards, is often as long and cumbersome as the initial development process. New technologi- cal innovations in medical devices may thus be barred from certain countries, either voluntarily or involun- tarily, because the standards for the devices have not evolved so quickly as the products themselves. Appendix I.—Governmental Regulation of International Trade in Medical Devices: United States, Canada, Japan, United Kingdom, France, Federal Republic of Germany, and Mexico’ United States Regulation of Imports Two types of government regulations affect the abil- ity of foreign medical devices to compete in the U.S. market. The principal focus of this appendix is the first type—those regulations that directly impose require- ments on foreign manufacturers and importers, or on the imported device itself. The second type of regula- tion indirectly influences the actual sales of imported medical devices by affecting their competitiveness with devices manufactured in the United States. The regulations of the Food and Drug Administra- tion (FDA) are designed to ensure that only safe, ef- fective, and truthfully labeled medical devices are sold in the United States. In theory, this means that foreign manufacturers and imported devices must meet the same criteria as U.S. firms and domestically manufac- tured devices. In practice, however, because of budg- etary constraints, foreign manufacturers of medical devices are treated somewhat differently, since they are not inspected so regularly as domestic manufac- turers, and, unlike their domestic counterparts, they receive advance notice of an upcoming inspection. The Customs Service, which is supposed to ensure that medical device importers comply with the gen- eral rules applicable to all imported products, in 1979 delegated certain of its general responsibilities to FDA (304). Requirements of the Food and Drug Administra- tion.—FDA regulations impose a number of require- ments that must be fulfilled before a device can even be considered for import approval, and these require- ments are the same as those imposed on domestic man- ufacturers (see ch. 5). Registration of a foreign manu- facturer of medical devices is voluntary, but FDA tries to encourage such establishments to register. Registra- tion is mandatory for the importer (initial distributor) of a foreign medical device (21 CFR 807.20, 1982). Unless the importer is registered, FDA will not allow the import to be released for sale in the United States. A foreign manufacturer or distributor must also supply FDA with a list of every device that it exports Excerpted from a paper prepared for OTA by Kaye, Scholer, Fierman, Hays & Handler (181). 216 to the United States (21 CFR 807.40, 1982) or author- ize an exclusive distributor to file the medical device listing on its behalf. Failure to list a device will result in its exclusion from the United States. Foreign manufacturers, unlike domestic producers, usually have at least 30 days notice prior to an FDA inspection. Because of the expense and logistics in- volved, foreign inspections by FDA are infrequent. Furthermore, it is likely that they will become even more infrequent in the future because of recent reduc- tions in FDA travel funds. The third set of FDA preimportation requirements involves premarket notification and approval. The scope of these requirements varies based on the nature and history of the product. If a product was being im- ported into the United States prior to the Medical De- vice Amendments of 1976, it may continue to be im- ported without notification. But if a device was not being imported prior to 1976, the manufacturer or im- porter is required to submit a premarket notification to FDA. If FDA finds that a product is substantially equivalent to a preamendments device, importation and marketing will be permitted. If a device is not substantially equivalent to a preamendments device, it may be subject to the further requirement of pre- market approval (see ch. 5). In that case, neither im- portation nor marketing of the device is permitted until approval is received from FDA. The fourth form of preimportation requirement relates to manufacturing. Both foreign and domestic manufacturing establishments are subject to inspec- tions to ensure compliance with good manufacturing practices, although the right of such inspection may be limited by foreign governments or the foreign firm involved. If a satisfactory arrangement for an inspec- tion cannot be made, FDA has the authority to exclude the product since it would be unable to determine whether the device met the good manufacturing prac- tices requirements of the Federal Food, Drug, and Cosmetic Act. (FDA has encountered few, if any, problems in inspected medical devices firms in the countries included in this appendix (204).) Pursuant to a 1979 delegation of some of the Cus- toms Service's authority, FDA monitors compliance with customs regulations, collects samples, issues notices of sampling, and issues notices of refusal of admission at certain ports (384). Figure I-1 outlines the steps involved in clearing customs. App. I—Governmental Regulation of International Trade in Medical Devices © 217 Figure I-1.—FDA Import Procedures for Foreign Medical Devices SOURCE: Office of Technology Assessment. 25-406 O - 84 - 15 218 e Federal Policies and the Medical Devices Industry There is no evidence to suggest that FDA regulations were adopted for the purpose of erecting barriers to international trade in medical devices, or that they are administered with such an intent. As a practical mat- ter, however, certain regulations do have a different impact on importers than on domestic manufacturers. For example, domestic producers may have an advan- tage with respect to participation in the notice and comment process and informal negotiations leading to the development of regulations. Not all regulations, however, operate to the advantage of domestic pro- ducers. For instance, due to logistical concerns, in- spections under the good manufacturing practices reg- ulations are more frequent, and undoubtedly more burdensome, for domestic producers than for foreign manufacturers. FDA has a variety of administrative sanctions equal- ly applicable to domestic and foreign manufacturers that can be used to prevent the marketing of adulter- ated or misbranded medical devices. There are, how- ever, important practical distinctions between FDA's authority over domestic medical devices and imported devices. In domestic commerce, FDA has only formal statutory authority to bring enforcement actions such as seizures with respect to devices when those devices are actually misbranded or adulterated. FDA's discre- tion is therefore limited by the requirement that it be able to prove that a device is in fact adulterated or misbranded. FDA's enforcement authority over im- ported devices is broader; it has the authority to act when an imported device appears to be misbranded or adulterated (21 U.S.C. 381(a), 1976; (294)). The “appears” standard significantly modifies the usual burden of proof and offers more discretion to FDA to detain or otherwise halt potentially defective or haz- ardous medical devices before they are distributed to consumers in the United States. On the basis of this authority, FDA actively monitors imports to prevent the introduction of offending devices. On the other hand, it must be noted that FDA has a variety of informal administrative remedies, such as regulatory letters or recalls, which it employs where it does not wish to institute a formal enforcement ac- tion. Some of these actions may be more difficult to apply to foreign manufacturers than to domestic man- ufacturers. Customs Service Regulations.—The result of the delegation of customs’ authority to FDA is that the only customs Service regulations applicable to medi- cal devices are those generally applicable to all im- ported products. These regulations fall into three cat- egories: those pertaining to “entry” of goods into the United States, those pertaining to the assessment of duties on imported products, and those which pertain to the physical appearance of imported goods. This classification system may change in the near future. The U.S. International Trade Commission recently prepared a study in anticipation of the con- version of the U.S. tariff classification into an inter- nationally agreed-upon, harmonized system of tariff classification. If adopted, the system will result in a more uniform classification of medical devices between different countries, and thus make the gathering of sta- tistical data easier, but it will have little economic ef- fect on imports into the United States. Tariffs applicable to medical devices are now gen- erally in the range of 5 to 10 percent, which is com- parable to the rates applied by other countries to the imports manufactured in the United States. The third set of regulations administered by the Cus- toms Service relate to the physical appearance of, and markings on, devices. Although these requirements must be met by importers, they have no significant impact on the pattern of trade in medical devices. U.S. Trade Laws.—In addition to being subject to FDA and Customs Service regulations, imports of medical devices are subject to regulation under the gen- eral U.S. trade laws. These laws, which are briefly de- scribed below, can be used to impose additional duties, quotas, or other restrictions on the importation of medical devices that might cause injury to the domes- tic medical devices industry. There are two basic cat- egories of such trade laws: those that impose restric- tions when imports that are traded “unfairly” injure the domestic industry, and those that permit restric- tions on imports where there is injury to the domestic industry, without regard to “unfairness.” The unfair trade laws have not often been invoked in the medical device area. Nor has any part of the medical device industry yet attempted to bring a coun- tervailing duty or antidumping case against imported medical devices. Two actions have been brought against importers of medical devices on the grounds of unfair trade prac- tices. In June 1982, the U.S. International Trade Com- mission instituted an investigation involving certain computed tomography (CT) scanner and gamma cam- era medical diagnostic imaging apparatus. The investi- gation involved allegations that equipment imported from Israel violated a patent granted to a U.S. com- pany (312). In March 1983, the commission made a preliminary determination that there was no violation and the case was terminated. In September 1983, the commission initiated a second investigation involving cardiac pacemakers and components (322). This com- plaint was also based on alleged patent infringement and is currently pending before the commission. App. |—Governmental Regulation of International Trade in Medical Devices e 219 Regulation of Exports In the United States, the export of medical devices is not regulated to anywhere near the same degree as imports. To the extent that export regulations do ex- ist, they are administered principally by two agencies, FDA and the Office of Export Administration (OEA) in the U.S. Department of Commerce. FDA Export Regulations.—For export purposes, medical devices can be divided into three categories. The first category of devices is by far the largest; any medical device that can be marketed legally in the United States can be exported legally from the United States without prior approval by FDA. The second category of devices are those that can- not be marketed in the United States, but that can be exported without FDA approval if the product (sec. 801 (d)(1) of the Federal Food, Drug, and Cosmetic Act): ® meets the specifications of a foreign purchaser, ® does not conflict with the laws of the country of the foreign purchaser, ® is labeled for export, and ® is not sold or offered for sale in domestic commerce. Prior FDA approval is not required for exports under section 801(d)(1), but FDA may at any time require an exporter to show that the exports that it is making under this section comply with the section's four re- quirements. The third category of medical devices, those ex- ported under section 801(d)(2) of the act, includes cer- tain types of adulterated or misbranded devices that may be exported only with specific FDA approval and not under the less strict standards of section 801(d)(1). The third category specifically includes products that violate performance standards; that are subject to but have not received premarket approval; that are sub- ject to limited investigational use, or that are banned in the United States. As a practical matter, most de- vices requiring FDA approval for export are those that require but have not yet received premarket approval or that are subject to limitations as investigational devices. To obtain FDA approval for export of a medical de- vice in the third category, an exporter must submit to FDA an “Export Request.” This request must contain a description of the device and its status under U.S. law, and a letter of acceptance from the government of the importing state. This letter of acceptance must state: e that the device is not in conflict with the laws of the importing state, e that the foreign government has full knowledge of the status of the device in the United States, and eo that the import is permitted (along with any re- strictions that might be imposed). On the basis of this information, FDA will approve the exportation of the device if it would not be con- trary to public health and welfare. The FDA approval process for exports under section 801(d)(2) raises two problems for U.S. exporters. The first arises from the need to obtain explicit authoriza- tion from the foreign government for the importation of a device and is also faced by exporters under sec- tion 801(d)(1). Since many countries have no laws governing the approval of medical devices, it is diffi- cult for these countries to inform FDA that a device is approved for import. In such cases, FDA will ac- cept a statement from a foreign government that it has no laws prohibiting the importation of a particular medical device. This procedure may only partially alleviate the difficulty because in many of these coun- tries no one is authorized by law to make even such a limited statement to FDA. The second problem is the vagueness of the “public health and welfare” stand- ard used in section 801(d). Neither the Medical De- vice Amendments of 1976 nor the legislative history indicate whose health and safety is to be protected by FDA. In practice, FDA's reliance on the standard is mini- mal; the decision to allow an export is usually made simply on the basis of whether the foreign government approves the importation of the device. From October 1, 1981 through September 30, 1982, FDA issued 260 letters approving export of medical devices under sec- tion 801(d). In the same period, eight requests were not approved. From October 1, 1982 through March 31, 1983, 116 approvals for export were given, five devices were not approved, and one previous approval was rescinded. Department of Commerce Export Controls. —Med- ical devices, along with all other U.S. exports, are subject to the export controls in the Export Adminis- tration Act of 1979. That act authorizes the President to impose controls on exports for reasons of national security, foreign policy, and short supply.? The prin- cipal authority to administer these controls has been given to the Commerce Department's OEA; other agencies including the Departments of State, Defense, Energy, and Treasury have an advisory role in OEA licensing decisions. The Export Administration Act originally expired on Sept. 30, 1983. The controls under the act were at first extended on a temporary basis by the President pursuant to the authority of the International Economic Emergency Powers Act. Congress later passed a bill extending the act until the end of February 1984. Congress is considering reauthorization with a variety of amendments, but it is not possible to predict what new provisions will be included. 220 e Federal Policies and the Medical Devices Industry All exports from the United States must be author- ized by either a general or a validated export license. A general license is an authorization to export granted by regulation rather than by specific application. Gen- eral licenses can be used to export any good to any destination, as long as neither the good nor the destina- tion is controlled. Validated licenses are required whenever the export of a specific commodity is con- trolled to a specific destination. Determination of whether a particular commodity requires a general or validated export license is made with reference to the Export Administration Regula- tions and the Commodity Control List. Medical devices fall into several product classifica- tions of the Commodity Control List, depending on the nature of the product and its technological sophis- tication. For example, most medical, surgical, and den- tal supplies are classifiable within the miscellaneous product group item 6999 G, “other commodities not elsewhere specified,” which can be exported under gen- eral license except to Cuba, Kampuchea, North Ko- rea, and Vietnam. Most X-ray equipment is classified in the Electronic and Precision Instruments Product Group in item 1533A, which requires a validated li- cense to any destination other than Canada. In most cases, the requirements applicable to medi- cal devices are less than clear because the Govern- ments interests in restricting exports are based not on their status as medical devices but on the fact that they include some form of technology that the United States wishes to control, such as computer or laser technol- ogy. An example can be seen in item 1522A, “lasers and laser systems including equipment containing them,” for which a validated license is required for all destinations except Canada. Although most medical laser systems would appear to be covered by this clas- sification, the explanation of this item in the Com- modity Control List provides no further specific guid- ance. Treatment of medical equipment incorporating semiconductor or computer technology can be even more complicated and can depend on the speed of the computer, its capacity, the capability of the computer, and the materials from which the semiconductor is made. Thus, similar medical devices could be classified as different items, with one requiring only a general license and the other a validated license because the latter has a computer that operates at a slightly higher rate of speed or because its semiconductors are made of a different material. This export control process and the intricate classi- fication system raise the level of uncertainty for med- ical device exporters. Whenever a validated license for a transaction is required, an exporter cannot be sure whether the export will be approved, in what form it will be approved, or how long approval will take. The eventual destination of the device raises addi- tional questions. It is probable that export licenses will be granted for the export to Western Europe or Japan of a medical device incorporating controlled technol- ogy. Export of the same device to a country in East- ern Europe or to the Soviet Union may or may not be allowed, depending on the discretionary decision of the Commerce Department as to whether the re- lease of the technology may hurt U.S. national secu- rity. Even if export approval is granted, conditions may be imposed, including substantial modification of a device in order to prevent the release of sensitive technology. The question for the exporter is whether a prospective buyer would be willing to accept a de- vice that is significantly different from that which the buyer originally intended to purchase. Regardless of whether the export of a medical de- vice is eventually approved, the length of time in- volved in the licensing process is a disincentive to ex- port. In most cases, the Commerce Department issues an export license in 4 to 6 weeks. This time frame, however, rests on the assumption that the export does not involve highly sensitive technology and is not destined for a sensitive country such as the Soviet Union, and that the exporter has supplied all the cor- rect documentation to the Commerce Department. De- lays occur when the exporter submits insufficient or incomplete information or when other agencies, usu- ally the Departments of State and Defense, exercise their right to review an application. In such cases, de- lays of months and, in extreme cases, years may result. A number of proposals currently being considered to facilitate export while protecting national security, such as elimination of export licenses to most West- ern European countries, reduction of controls in situ- ations where identical technology is available from other foreign sources, and reconsideration of which technology is deemed to be militarily sensitive, may remove many medical devices from controls. Simi- larly, Administration moves to ease restrictions on ex- ports to China will open up that market to increasing numbers of U.S. medical devices. U.S. Government Export Promotion Activities Department of Commerce.—Most Government ex- port promotion activities are centered in the Depart- ment of Commerce. Among the department's export promotion activities are the Export Trading Company program, the dissemination of information about standards, the development of market research data, and the activities of the Foreign Commercial Service. Under the Export Trading Company Act (Public Law 97-290) groups of U.S. exporters are able to com- bine their resources to aggressively seek export mar- App. |—Governmental Regulation of International Trade in Medical Devices ¢ 221 kets. Groups of medical device exporters or even a single medical device manufacturer may obtain a cer- tificate from the Department of Commerce enabling them to engage in certain activities that would other- wise be prohibited under antitrust laws. There has been little experience in the operation of export trading com- panies, and it will be some time before it can be deter- mined whether the program will in fact significantly promote U.S. exports. At the present time, no medi- cal device manufacturers appear to have attempted to establish export trading companies. A second Commerce Department function of poten- tial significance to the medical device industry is the compilation by the National Bureau of Standards of lists of applicable foreign standards. This project has not yet been completed, but when it is, the ready avail- ability of applicable foreign standards will be of help to U.S. medical device exporters. There is currently no compilation of medical device standards. FDA's Bu- reau of Medical Devices publishes an annual survey of standards for medical devices, but it simply iden- tifies relevant standards of most major U.S. trading partners and does not reproduce them. The actual standards are available only from sources in the for- eign country, or, in some cases, from private organi- zations in the United States, such as the American Na- tional Standards Institute, Inc. The Department of Commerce also provides a va- riety of resources for potential exporters, including market research and computerized lists of market op- portunities. The department has, for example, com- missioned detailed market surveys of the medical de- vice markets in a variety of countries. These Country Market Surveys include information about market conditions, the status of foreign competitors, the ma- jor end-users, and forecasts of the markets for particu- lar medical devices. Also included are brief reviews of foreign government regulations. The department also maintains lists of potential purchasers of U.S. goods. Although the services provided in the Department of Commerce are not a substitute for individual mar- ket analyses by an exporter and do not eliminate the exporter’s need for competent assistance in the foreign market, they do provide some help, particularly to first-time exporters to certain markets. Department of the Treasury.—The most significant financial export incentive provided by the U.S. Gov- ernment and available to exporters of medical devices is the “DISC” export tax system. Under the DISC pro- visions of the income tax code, a corporation engaged in export trade may set up a corporation called a Domestic International Sales Corp. (DISC), through which it channels its export sales. It is then permitted to defer tax on portions of the income of the DISC. Under the complicated accounting rules applicable to DISC taxation, the amount of income thus sheltered varies, depending on the level of export sales made by the DISC, but generally up to 20 percent of the income generated by export sales can be sheltered. The DISC system is currently under congressional review. International criticism of the DISC system as an illegal export subsidy persuaded the United States to make a commitment to its foreign trading partners to eliminate it. There are several possible replacements for the DISC system pending before Congress. U.S. Trade Representative.—The U.S. Trade Rep- resentative (USTR) is the principal U.S. negotiator for international trade agreements. USTR represented the United States at the Tokyo Round of the Multilateral Trade Negotiations, held under the auspices of the General Agreement on Tariffs and Trade (GATT), which led to the development of the Standards and Government Procurement Codes. The Standards Code is an agreement among the signatory countries, in- cluding most major export markets for U.S. medical devices, not to use standards as nontariff barriers (see app. H). The Government Procurement Code is an agreement to expand the opportunities of foreign sell- ers to compete for Government contracts. By seeking to enforce U.S. rights under these agreements, and by negotiating for an expansion of their scope, USTR can play a role in expanding foreign markets for U.S. med- ical devices. USTR also conducts bilateral negotiations to remove specific trade barriers to U.S. goods. The issues are usually brought to the attention of the USTR by pri- vate industry. For instance, USTR has been negotiat- ing a reduction in Japanese medical devices trade bar- riers for the last year. The U.S. medical device industry brought to the attention of USTR a number of Japa- nese import procedures that had the effect of signifi- cantly limiting the access of U.S. products to the Jap- anese market. Among these barriers were regulations requiring chemical testing for devices, restrictions on changes in import agents, complex procedures for ap- proving minor device changes that do not affect health and safety, and the generally slow process leading to approval of medical devices. Negotiations between the Japanese and USTR have had limited positive results, with some restrictive procedures having been modi- fied to accommodate U.S. concerns (see below). Canada The Canadian market for medical equipment, in- cluding medical devices, was approximately $440 mil- lion in 1981 (241). By 1980, imports of medical equip- ment had reached an estimated $391 million annually, constituting 88 percent of the total market. By far the 222 e Federal Policies and the Medical Devices Industry largest share of the imports, 82 percent in 1980, came from the United States, and many of the domestic Canadian medical device manufacturers are owned by U.S. firms. Canada has had universal health insurance since the early 1970s. Import Requirements There is no import license required for medical de- vices. However, under regulations issued by the Min- istry of National Health and Welfare, it is illegal for any person to import for sale any device which does not meet the specific requirements relating to safety, efficacy, and truthful labeling of the Canadian Food and Drug Act or the Medical Device Regulations (255). As in the United States, goods found to be noncon- forming may be relabeled or modified by the importer to meet Canadian requirements. In addition, within 10 days of the first sale of a de- vice in Canada, importers are required to provide in- formation to the Health Protection Branch of the Min- istry of National Health and Welfare regarding the foreign manufacturer or importer, the Canadian dis- tributor, the model number, any drugs present in the device, statements of the uses for which the device is being offered, and the method(s) of sterilization, if any, recommended by the manufacturer. Extra-oral dental X-ray equipment is subject to spe- cial import restrictions (254). Imported radiation- emitting devices must comply with all applicable standards regarding design, construction, and func- tion. Canada will accept X-ray devices certified under U.S. FDA performance standards. Tariffs on medical devices now average approx- imately 15 percent and are expected to be reduced to 9.5 percent by 1985 under GATT commitments al- ready made by Canada (241). Product Approval Process Both imported and domestically manufactured med- ical devices are regulated by the Health Protection Branch of the Ministry of National Health and Wel- fare, which carries out laws such as the Radiation Emit- ting Devices Act, the National Health and Welfare Act, the Food and Drugs Act, and the Hazardous Products Act, which concern the types of information required to be submitted and the timing of the submissions. Under the Canadian product approval system, the manufacturer or importer of a medical device must conduct premarket tests and present the results to the Health Protection Branch. The data must indicate the benefits and performance results claimed for the de- vice. In addition, at any time the manufacturer must be prepared, if requested, to provide to the Assistant Deputy Minister of the Health Protection Branch in- formation on test methods and test results (255). Only recently has the Canadian Government begun to develop regulatory standards for medical devices. The Bureau of Medical Devices in the Health and Pro- tection Branch of the Ministry is concerned with the technical and scientific aspects of medical device reg- ulation regarding the quality, safety, and efficacy of medical devices (241). The bureau conducts research to allow it to enact specific safety and performance standards for various types of medical devices and to develop test methods to evaluate conformity with these standards. It also tests devices for compliance with standards, to assess manufacturer's claims for safety and efficacy, and to evaluate newly suspected hazards in previously approved devices. In addition to its scientific duties, the bureau accu- mulates information on sales of medical devices in Canada and monitors recall developments in foreign countries. When appropriate, it also initiates recalls of imported devices. Only a few types of medical devices are presently subject to mandatory standards promulgated by the bureau (241). In addition to the standards for radia- tion-emitting devices, there are now national stand- ards on leakage of current from electromedical devices and the design and operation of oxygen inhalators. These standards tend to be similar, though not iden- tical, to U.S. standards. The bureau has also enacted regulations requiring premarket review of all implantable medical devices and submission by the manufacturer of safety and ef- fectiveness data. It is expected that the bureau will issue additional standards for a number of medical devices in 1984—including labeling and packaging standards for radioenzyme testing devices, infant incubators, medical gas cylinders, and ozone emissions from med- ical devices. Medical devices that are “new” within the definition of the Canadian Food and Drugs Act are subject to additional regulatory requirements first imposed in 1975 (255). At the present time, the only products that fit this category of “new” devices are intrauterine devices, cardiac pacemakers, prolonged-wear contact lenses, and intraocular lenses. Even these devices are considered new only if they have not previously been sold by the same manufacturer in Canada, differ from a device previously sold by the same manufacturer in Canada, or are identical to a device previously sold in Canada by the same manufacturer but recalled or withdrawn from the Canadian market. To be sold in Canada, new devices must receive a Notice of Com- pliance from the Health Protection Branch. In addition, it is usually necessary for manufacturers of certain medical devices to comply with standards App. |—Governmental Regulation of International Trade in Medical Devices 223 set by the Canadian Standards Association, an inde- pendent, private body. The association has two gen- eral specifications that govern X-ray equipment and electromedical equipment. Provincial governments en- force compliance with these standards (241). Other Market Factors Other than tariffs, which are temporarily somewhat higher than in the other developed countries in this study, the Canadian market remains remarkably free of direct and indirect import barriers. The health care delivery system does not discriminate overtly against purchase or use of foreign medical devices. However, the Canadian Federal Government has had a practice of granting a preference to goods of Canadian origin when making purchasing decisions. This has taken the form of accepting bids by Canadian suppliers that are within a specified range (5 to 15 percent) of the lowest bid offered by a firm importing similar goods. Some provinces, particularly Ontario and Quebec, have adopted similar preferences for products from within the province. Although the Federal and Pro- vincial governments purchase most of the medical devices sold in Canada, the effect of their procurement policies on imports has not been as great as might have been expected, probably because except for disposables the Canadian medical devices industry is not well de- veloped. Japan The Japanese market for all medical equipment, in- cluding medical devices, was estimated to be about $1.24 billion in 1982 (122). The share of the Japanese medical equipment market held by imports has in re- cent years been only about 23 percent, one of the lowest percentages for any industrialized country ex- cept the United States. The United States is the largest supplier of medical equipment in Japan, providing ap- proximately 60 percent of all such imports in 1982. Import Requirements Special technical import requirements apply to many products, including medical devices. When a de- vice is subject to one of these technical requirements, a firm must apply to the Ministry of International Trade and Industry (MITI) for an import quota cer- tificate. In addition, U.S. products that require an ex- port license under the U.S. Export Administration Act or are subject to other U.S. export controls must also have an import certificate. Most medical devices are also subject to technical inspection at the point of en- try to Japan to assure that any applicable standards have been met. Under the Pharmaceutical Affairs Law, importation of medical devices into Japan must be approved by the Ministry of Health and Welfare unless the devices bear the Japanese Industrial Standards Committee (JIS) mark of approval (243). The term medical device in- cludes instruments for use in the diagnosis, cure, or prevention of disease in man or animals, or intended to affect the structure or function of the body and which are designated by Cabinet Order. Two types of licenses are necessary to import a med- ical device. The first is a license for professional im- portation, a general license required of all importers, which signifies that a company or person is qualified to sell medical equipment in Japan. The purpose of this licensing procedure is to ensure that each company im- porting medical equipment to Japan has the capabil- ity and knowledge to service the equipment and in- struct purchasers in its proper use. Each office of an importing firm must be separately licensed for profes- sional importation. These licenses are valid for only 3 years. Each type of medical device to be imported must also be granted a separate product license, which is to ensure the quality, safety, and efficacy of the de- vice (243). To be granted a license, the device, if it has not already received the JIS mark, must go through a time-consuming and rigorous testing and approval process. Virtually any modification in the design or type of a device being imported, even if it does not change the product's performance, requires a repeti- tion of the product approval process discussed below, as though an entirely new product was being licensed. Until August 1983, only an importer could apply for a product license. The theory behind this require- ment was that the importer, rather than the foreign manufacturer, actually stood behind the device in Ja- pan for product liability and all other purposes. For this reason, transfer of a product license from one im- porter to another was forbidden. The effect of this re- quirement was to limit drastically the ability of over- seas suppliers to change their Japanese distribution agents, since switching agents required submitting a new product license application, causing delays of 6 months to 2 years. In response to growing pressure from European and U.S. Government agencies (3) and trade groups, the Japanese Ministry of Health and Welfare in April 1983 announced planned changes in the importer and prod- uct licensing process (173). The most significant mod- ification was that, effective August 1, 1983, a foreign manufacturer could apply for a product import license. The foreign manufacturer must submit the same docu- 224 e Federal Policies and the Medical Devices Industry ments and data relating to a device's safety and efficacy that are required of an importer applicant and desig- nate an “in-country caretaker,” who handles the re- sponsibilities ordinarily imposed on a domestic man- ufacturer. Approval of a foreign manufacturer's product im- port application also depends on the payment of all costs for an onsite inspection of the foreign manufac- turer's overseas facilities. Theoretically, all U.S. man- ufacturers importing new devices to Japan will be sub- ject to inspection. A “grandfather clause” limits the applicability of this new system to medical devices not currently on the Japanese market. A recent change in the regulations issued under the medical device law allows product licenses to be transferred from one im- porter to another in certain cases. Japan applies GATT tariffs to medical devices. The rates now average between 6 and 8 percent and are scheduled to decrease by 0.5 percent on average in 1984 (122). Japan has adopted the basic Customs Co- operation Council Nomenclature (CCCN) for purposes of classifying imports, including medical devices. Product Approval Process Applications for approval of the product license dis- cussed above are made to the local prefectural gov- ernment and must be accompanied by the results of clinical tests conducted in Japan (242). If the device is identical to an already approved item or has received the JIS mark, approval by the Pharmaceutical Affairs Bureau is automatic. Otherwise, a minimum of two clinical studies conducted in authoritative general or university hospitals is required. Because tests con- ducted only on Japanese nationals are acceptable, U.S. firms have to repeat clinical tests in Japan that have already been conducted elsewhere (3). The time elapsed between submission of an applica- tion and the receipt of final approval is a minimum of 3 months and can be as much as a year or more (215). The Government official responsible for the re- view need not inform the manufacturer in advance of the data needed and may require additional studies and information. As a result, considerable time elapses if the Ministry of Health and Welfare returns applica- tions for more data. Another problem that has been raised during U.S.- Japan discussions of medical device regulation is the need to apply to local prefectural offices, which then forward data to the Ministry of Health and Welfare. The U.S. Government has urged Japan to allow local prefectures to approve routine applications, such as changes in the color and size of a product. JIS, a part of MITI, has broad powers to establish standards for industrial products. JIS standards are not usually identical to the corresponding international or U.S. standards. Although devices are not required by law to conform to JIS standards, and some domes- tically manufactured items that do not conform are actually sold in Japan, it is very difficult to import and sell products that do not conform to JIS standards. Foreign manufacturers can apply for permission to attach the JIS emblem to their products under the In- dustrial Standardization Law (Law No. 185, 1949, revised 1980). Permission to use the mark is given on a plant-by-plant basis after an onsite inspection by offi- cials of the applicable Ministry. Depending on the nature of the medical device, permission to use the JIS mark must be approved by MITL. JIS has promulgated hundreds of standards relevant to medical devices (122). The general standards are usually similar to the standards promulgated by the International Electro- technical Commission. Specific JIS standards have been established for some electromedical devices in- cluding cardiographic, electroencephalographic, and audiometric. A program is now under way to put into place specific standards for 38 additional electromedi- cal devices. Under the Pharmaceutical Affairs Law, the Minis- try of Health and Welfare has developed its own stand- ards for certain medical devices such as contact lenses and artificial heart valves for which sterilization is par- ticularly important. Products for which Ministry standards have been developed require for importa- tion certification that they conform with the standards. Obtaining this certification involves testing samples in Japan. Other Market Factors Both established business practices and Government regulation hinder the importation of medical devices into Japan. The Japanese Government has set up the GOTODA Committee to study ways of bringing the Japanese cer- tification process and standards more in line with in- ternational practice (195). The committee's recommen- dations have led to Government modification of some regulations, such as the product import license scheme above. However, a number of regulatory barriers have remained, such as the requirements that clinical testing be performed on Japanese people; that electromedical devices remain at the point of entry until they have been inspected and approved for release; and that the product approval process be repeated for very minor modifications not affecting a device's performance or safety. Many U.S. firms operating in Japan also believe that the Japanese Government enforces its product licens- ing requirements unequally, to the disadvantage of im- App. I—Governmental Regulation of International Trade in Medical Devices e 225 porters. Because the Ministry of Health and Welfare lacks a domestic enforcement arm similar to the FDA's field force, violations of the product licensing require- ment may go undetected. The existing system of distribution is also a stumbling block to expansion of the import market in medical devices. U.S. firms and their subsidiaries have gener- ally relied on domestic sales agents to sell their prod- ucts. Direct sales by importers to end-users were unheard of until the recent changes in Japanese regu- lations effective August 1, 1983. Direct sales will prob- ably remain rare for a while, given the importance of personal ties to the market and the requirement that foreign firms wishing to sell to an end-user must ob- tain a license for professional importation which in- volves inspection of each plant where the product is manufactured. Such licenses, however, are not re- quired for import sales to distributors or other firms that resell the equipment to end-users. Although most U.S. manufacturers of medical de- vices have not had Japanese subsidiaries, a growing number of U.S. firms, including Beckman Instruments, Inc., American Hospital Supply Corp., and Baxter Travenol Laboratories, Inc., have set up subsidiaries to promote Japanese sales. Using subsidiaries assures buyers that the seller has the knowledge and ability to give proper instruction in use of the device and to service it after sale, both important factors in selling very sophisticated electromedical devices. Sales to an agent remain the most common form of product distribution, not only for medical devices but also for many other imported products. However, the system of selling through agents results in one or more markups of the device's price, which pushes the price of foreign products above those of comparable Japa- nese products. United Kingdom The United Kingdom has traditionally been a ma- jor market for medical devices because of its exten- sive and sophisticated health care system. In 1982, total sales of medical equipment in the United Kingdom were in excess of $600 million (52). The size of the U.K. medical device market is linked directly to expenditures for the nationalized health care system, which has slowed considerably during the 1980s. In 1982, the United Kingdom imported $537 million of medical devices. The United States had the largest share of the total U.K. import market for medical devices with 28 percent, up from 25 percent in 1980 (52). It is expected that the U.S. share will continue to increase to nearly 36 percent of total imports by 1987. Increases in medical device imports from other major suppliers will reflect both increased competition among foreign suppliers to maintain their sales and de- creased sales by U.K. domestic suppliers. The major new products in which U.S. suppliers are expected to do well over the next 5 years are high-technology items, such as laser technology, fiber optics, and micro-surgical equipment. Import Requirements The general British import regulations applicable to all imported goods do not appear to significantly im- pede the importation of medical devices (105). Nor are foreign manufacturers of medical devices required to obtain Government-issued clearances when their goods are imported into the United Kingdom. Foreign con- cerns are permitted to negotiate directly with the end- user, and there is no requirement that the transaction be reported to the Government. Imported medical de- vices are subject only to routine customs procedures. As a member of the European Community, the United Kingdom does not impose tariffs on the prod- ucts of European Community member states. There- fore, members can sell medical devices in the United Kingdom at a competitive advantage. The United Kingdom along with many other European countries adheres to the CCCN for the classification of medical devices. Having a standardized category of goods simplifies the import and export of medical devices. British tariff duties do not impose a substantial bar- rier to the importation of medical devices. The duty rates on most medical devices range from 5 to 8 per- cent ad valorem and are generally comparable to or slightly below similar tariffs in the United States. Cer- tain medical device imports, such as those intended for training and research or for sale to nonprofit in- stitutions may be exempted altogether from the im- position of duties. In addition to being subject to duties imposed on devices from non-European Community countries, all imported medical equipment is subject to a 15-percent value-added tax (VAT) imposed on the duty-paid value of the goods. The VAT is imposed in order to equalize the treatment of imported devices with those manufactured in the United Kingdom, which are al- ready subject to a VAT. Product Approval Process Although medical devices sold in the United King- dom are not generally subject to the drug laws or to any mandatory scheme comparable to the controls ex- ercised by the FDA, regulations do apply to the medi- cal device market. Many medical devices are regulated by two divisions of the Department of Health and 226 e Federal Policies and the Medical Devices Industry Social Security. The Medicines Division controls the manufacturing, licensing, clinical trial, certification, safety, efficacy, pre-market approval, labeling, quality control and adverse-reaction reporting of those devices subject to the provisions of the Medicines Act of 1968, as amended. Although the Medicines Act applies pri- marily to drugs, it also covers such devices as surgi- cal sutures, dental filling substances, contact lenses, intrauterine contraceptive devices, and certain radioac- tive medicinal products (174). The Supplies, Industries, and Exports Division ad- ministers the Drug Tariff, which lists products that may be prescribed and distributed through the Nation- al Health Service (NHS). In addition, this division sets specific purchasing requirements for such medical devices as X-ray equipment, hemodialysis machines, and surgical implants (174). The activities of the divi- sion are focused on devices that the Government pur- chases in large volume and on products that, if found to be defective, would pose a substantial hazard to the public health and welfare. Through the Supplies, In- dustries, and Exports Division, the Government, which is by far the largest purchaser of medical devices, rou- tinely sets quality and safety standards for the prod- ucts it purchases. These standards, adhered to by domestic procedures, must be complied with by im- porters in order to sell in the U.K. market. The Government also influences, unofficially, the types and specifications of other medical devices through a voluntary system of manufacturer registra- tion that operates through the National Health Serv- ice (174). Under the control of the Scientific and Tech- nical Branch of the Supplies, Industries, and Exports Division, this system allows manufacturers of medi- cal devices to voluntarily register their businesses under certain “good manufacturing practice” guides that have been developed in consultation with British trade associations. Registration certifies that equipment manufactured by the concern meets certain safety and effectiveness criteria. The guides cover the entire manufacturing process, from training of personnel to packaging, la- beling, and possible recall. The first guide, applicable to sterile, single-use medical devices, became effective in 1982. Guides are expected to be issued for numer- ous areas in the future. Although NHS hospitals are not required by law to make purchases from registered manufacturers, the system contains incentives to encourage registration. The Health Service Supply Council will circulate lists of registered manufacturers along with a recommen- dation that products should be purchased only from listed manufacturers. In effect, then, the Scientific and Technical Branch'’s advisory standards will guide the purchase of medical equipment by NHS hospitals. Be- cause these hospitals do most of the medical equip- ment purchasing, it will generally be good business practice for a device manufacturer to register under a “good manufacturing practice” guide, if one applies. The combination of standards for Government pur- chases and reliance by private purchasers on those standards acts as an unofficial regulatory scheme for both imported and domestic medical devices sold in the United Kingdom. The result is a degree of regula- tion of medical devices, that, though lacking a statu- tory basis, is as pervasive as that existing in almost any other country. The “voluntary” registration pro- cedure will soon augment the power of these indirect controls even further. Certain medical devices, including electrical and radiological medical equipment, must also comply with standards issued by the British Standards Insti- tution (BSI) (52). These standards may pose signifi- cant obstacles to U.S. manufacturers, since compliance with U.S. standards does not always satisfy all U.K. requirements. In general, compliance with the stand- ards of BSI is now as important in the sale of electri- cal medical devices as compliance with a standard developed by the Supplies, Industries, and Exports Division. Other Market Factors Since Government agencies purchase the vast ma- jority of all medical devices sold in the United King- dom, marketing strategy must be aimed at Govern- ment, rather than private, procurement. Purchases by Government hospitals and other agencies have in the past been made primarily at the local level, rather than through a centralized purchasing system. This decen- tralized purchasing system for NHS hospitals has resulted in hospitals’ buying equipment which may not be exactly what they need, or paying more for equip- ment because they are not buying in large quantities. In an effort to overcome these problems, NHS has recently revised its purchasing procedure to set up 17 regional purchasing centers and a new, national Supply Council to act as a central purchasing agency for high- volume equipment purchases (52). France The French market for all medical equipment was an estimated $356 million in 1980, with imports ac- counting for about 70 percent of that market (286). Exports of French medical equipment have averaged about 80 percent of imports to France. During the last decade, the United States replaced West Germany as App. |—Governmental Regulation of International Trade in Medical Devices o 227 the leading exporter of medical equipment and in 1980 provided about 24 percent of all imported medical equipment to France. Import Requirements In addition to the regular documents for import, nu- merous medical devices require technical visas, which permit surveillance of the quantity and price of im- ports (286). Technical visas are required for anesthetic equipment, syringes and surgical supplies, special diag- nostic equipment, blood transfusion apparatus, and electrostatic units containing artificial radioactive elements. Tariffs on most imported medical equipment range between 5 and 13 percent (286) and apply only to goods outside the European Community. Under com- mitments made at the Tokyo Round of GATT, these tariff rates should decrease slightly over the next few years. France does impose a VAT of 17.6 percent on most goods, including medical devices, regardless of their source. Product Approval Process A combination of technical standards and product approval requirements necessary for government pur- chases and reimbursement payments constitutes an in- direct but comprehensive system of regulation. The ef- fectiveness of this system is increased by the reliance private parties place on official standards in making their own purchasing decisions. The French Pharmacopeia?® sets forth detailed purity standards for drugs and “sterile devices,” such as sur- gical dressings, sutures, certain implants, absorbent cotton, and a variety of plastic products. Pharma- copeia requirements technically apply only to prod- ucts that are sold to public institutions or to products that claim to comply with the Pharmacopeia. How- ever, their role in practice is far broader, since private purchasers also rely on compliance with Pharmacopeia requirements as an indication of quality (164). For certain medical devices that are to be sold to public institutions, French law requires official gov- ernment approval through “homologation.” The Com- mission d'Homologation periodically lists certain cat- egories of devices that must be approved before they can be purchased by a public institution. Manufac- turers must formally apply to the commission, which requires submission of test reports by the manufac- 3The French Pharmacopeia has semiofficial status in France, under the authority of the Ministry of Public Health. Although its definitions, proce- dures, and standards do not have the same force and effect, as for example, FDA regulations in the United States, it is used as a guideline to identify health and safety violations associated with various drugs and medical devices. turer. At the end of the process, a proposal is made to the Ministry of Health, which issues an approval decree and a homologation number (164). Many man- ufacturers submit their products to the homologation process even when they are not required to do so, be- cause products with official approval have a larger market. Certain medical devices sold to public agencies are also subject to technical standards developed with the cooperation of industry and the Association Frangaise du Normalization (AFNOR), a governmental stand- ards body. These standards are imposed by various agencies of the national government (286). These prod- ucts may not be imported unless the Ministére de 1'In- dustrie, du Commerce et de I'’Artisunat has certified that they conform with the applicable technical stand- ards. If the relevant standards are developed or ad- ministered by a department other than the Ministere de I'Industrie, initial testing and approval of the de- vice will be done by that department. The difference between the AFNOR standards and those under the homologation process is that the AFNOR standards cover very technical matters such as the electrical workings of a device, while the homo- logation process is a much more general product ap- proval process dealing with both electrical and non- electrical devices. Compliance with AFNOR standards can be useful in marketing a product. Conformity is shown by an “NF” mark on the label, which can only be used with permission of AFINOR after testing of the product and inspection of the manufacturing premises. * Other Market Factors Government procurement is a very important fac- tor in the French medical device market, with pur- chases by public hospitals accounting for the largest segment of the market. A central purchasing group representing public hospitals, the Union de Groupe- ments d’Achats Publiques, accounts for over one-half of the medical equipment purchases by all public hos- pitals (376). Acceptance by this group can assure a product's success, particularly since private purchas- ing decisions tend to follow government procurement decisions. Government purchases are made in one of three ways: through privately negotiated contracts, through competitive bidding, and through bidding where fac- tors other than price are considered. But despite France's adherence to the Agreement on Government Procurement under GATT, a 1975 “Buy French” pol- icy does apply to purchases of numerous products— including external blood collection systems, hyperbaric “See Exporters’ Encyclopedia, at 2:481-482 (105). 228 e Federal Policies and the Medical Devices Industry chambers, body scanners, and artificial kidney ma- chines (286). The requirement for Ministry of Public Health “advice” on purchases of “innovative” equip- ment by the public sector (previously limited to “heavy equipment”) often takes the form of approved lists of suppliers. In addition, an effort is being made to strengthen the capabilities of regional health authorities for pro- viding advice on contemplated purchases. Such “ad- vice” is unlikely to favor U.S. suppliers if viable local alternatives exist, or where a manufacturer is a signif- icant local employer. Indeed, U.S. manufacturers have been informed that new products will not be approved by the French authorities for purchase where there is a competitive French-manufactured device (284). France also requires companies importing diagnos- tic products to set up a quality control laboratory in France to recheck every shipment, regardless of wheth- er it has undergone quality control audits in the coun- try of origin. No shipment of medical devices will be licensed without testing in a Government-approved laboratory (444). Federal Republic of Germany In 1980, sales of medical equipment and supplies in the Federal Republic of Germany totaled more than $1.5 billion (188). In 1979, the United States was the leading foreign supplier of medical equipment with 25 percent of imports (377). Import Requirements Products of European Community, Western Euro- pean, and developing countries are not subject to im- port duties (188). Tariff rates applicable to medical equipment from other countries average 6 to 9 per- cent, with a maximum of about 11 percent. Most im- ports are subject to a VAT of 13 percent, similar to the VAT levied on domestically manufactured prod- ucts. Some imported manufactured products are sub- ject to special excise taxes in addition to the “import equalization tax.” Foreign exporters to West Germany who must pay both the tariff and the “import equaliza- tion tax” face a significant disadvantage (216). Product Approval Process Regulation of medical devices is similar to that ex- isting in the United States prior to the passage of the Medical Device Amendments of 1976, with regulation of some products as an outgrowth of the regulation of pharmaceuticals. The 1976 Law on the Reform of Drug Legislation pertains to “fictitious drugs,” which include devices containing a drug, devices to be intro- duced into the body, dressings and surgical sutures, and diagnostic products (94). Specific regulations have been promulgated to govern manufacture, licensing, clinical trials, reporting of adverse effects, and liability for damage caused by drugs. Although fictitious drugs are not now subject to these regulations, the regulations could be extended to them in the future. Under the Drug Reform Law, the government also has a number of enforcement tools that can be used against regulated devices con- sidered misleadingly labeled, unsafe, or ineffective. Two provisions of the law are of special interest to importers. First, surgical suture material and certain diagnostic products may be imported outside the Euro- pean Community countries only if the importer ob- tains certification from a competent authority of the manufacturing country (such as FDA in the United States) that the World Health Organization's good manufacturing practices have been adhered to or that the import is in the interest of the general public. West Germany is in the process of adopting its own GMP regulations for the pharmaceutical industry, and these will apply to manufacturers of fictitious drugs. Second, the law requires any person who markets a medical device that comes under the Drug Reform Law to maintain a place of business within West Ger- many. The European Community recently ruled that this requirement is illegal and has asked that it be abol- ished, but its future is uncertain. Although the Drug Reform Law covers a relatively small segment of the medical device industry, a much larger segment is indirectly regulated. Regulations issued under the German General Technical Law re- quire that the manufacturer of technical medical equip- ment is in proper condition and that either the manu- facturer or an expert has subjected the devices to final inspection (192). Test protocols may be required from the manufac- turer for certain types of equipment, and testing must be carried out at one of 34 designated institutions. Testing for most medical devices is voluntary, but is often performed because it has some commercial value for the manufacturer. However, proposals have been circulating in West Germany to make testing under this law mandatory for all electromedical devices. Regulation of medical devices also occurs on a piece- meal basis through the work of the Deutsches Institut Fur Normung (DIN), the official standards body in West Germany. DIN has developed standards in such areas as the testing, storage, labeling, and packaging of products, and the materials, dimensions, and toler- ances to be used in manufacturing for a large number of medical devices. Among the medical items for which standards exist are surgical dressings, implants, and transfusion and hematological equipment. Although App. |—Governmental Regulation of International Trade in Medical Devices 229 compliance with an applicable DIN standard is not re- quired by law, in practice it can be a major advan- tage in the marketplace to have a DIN mark of ap- proval on a product. Moreover, much interpretation of DIN standards is done in practice by West German test laboratories whose approval is very important for marketing a product in West Germany (458). West Germany has a pharmacopeia, but with only limited applicability to medical devices. Its main focus is drugs and only a few medical devices, such as sur- gical sutures and dressings, are included. Other Market Factors West Germany is a signatory to the GATT Agree- ment on Government Procurement. Although govern- ment spending represents a substantial portion of all health care expenditures, purchases of medical devices are for the most part decentralized without the direct involvement of Government agencies. In practice, the chief physician in a hospital or in one of its depart- ments makes all purchasing decisions. The major ex- ception involves purchases of $75,000 or more by university clinics. Such purchases must be approved by the German Research Association. There is no offi- cial “Buy German” policy, but the tendency of pub- licly financed health care institutions is to purchase West German products. Mexico The market for medical equipment in Mexico is small but growing. Approximately $44.2 million was spent during 1980 on medical equipment, including medical devices (28). Imports account for nearly 85 percent of all purchases of medical equipment. The United States is the largest exporter, with 38 percent of the market in 1980. The Federal Republic of Ger- many (18 percent in 1980) and France (9 percent in 1980) are closest U.S. competitors. Devices for which production is labor-intensive are generally supplied do- mestically, while devices that require highly techno- logical processes are often imported. Import Requirements The Mexican system of import control involves a dual scheme of licensing and tariffs (105). Importers may obtain a license by applying to the Ministry of Commerce. The request is considered by one of 13 committees that specialize in a particular portion of the tariff or by a special committee that considers license requests by Government agencies. Requests are usually acted on within 2 weeks. Imports by govern- 25-406 O - 84 - 16 ment agencies must be approved in advance by the Public Sector Imports Committee, and approval will be withheld if a domestic product is available which is reasonably competitive in price and quality. Mexico maintains no special import requirements for most medical devices. One exception to this is that all devices to be physically connected to a patient re- quire import permits from the Ministry of Industry and Commerce and the Ministry of Health and Assistance (378). However, these permits are neither difficult nor costly to obtain. The majority of medical devices imported into Mex- ico are subject to tariffs which range from 2 to 35 per- cent (28). The median tariff is in the 10- to 15-percent range, somewhat higher than other countries in this study. The Mexican tariff generally follows CCCN. Mexico is not a signatory to the GATT. However, the only countries with preferential tariffs are other mem- bers of the Latin America Integration Association (Argentina, Bolivia, Brazil, Colombia, Chile, Ecuador, Paraguay, Peru, Uruguay, and Venezuela) (378). Product Approval Process There is no specific system of product approval for medical devices under Mexican law. Certain devices, however, require approvals from Mexican commis- sions that act as counterparts to U.S. utility commis- sions. For example, all electrical devices must be ap- proved by the Federal Electricity Commission, a state- owned corporation, and equipment incorporating radioactive materials must receive approval from the Nuclear Energy Institute (378). There are also no offi- cial standards governing the design or use of medical equipment in Mexico. Medical products, for the most part, can be brought directly into Mexico without any preimport procedures. Other Market Factors The size of the Mexican medical device market and the import share of that market are limited by a num- ber of factors. First, over 70 percent of all health care expenditures in Mexico are Government-controlled (28). The emphasis of the two major Government agencies involved in the provision of health-related services, the Institute for Social Security and the Sec- retariat of Health and Security, and of Mexican health care providers in general, is on the provision of basic health care services. As a consequence, there is a very limited market for sophisticated high-technology med- ical equipment, such as CT scanners and cardiac diag- nostic equipment, in which the U.S. medical device industry is particularly strong. 230 ¢ Federal Policies and the Medical Devices Industry Mexican governmental purchasing practices evi- dence a strong preference for domestically produced items. The Government will procure medical equip- ment from foreign manufacturers only when the equip- ment cannot be domestically supplied. Indeed, the Government has a “closed border” policy under which it will ban imports of products that compete directly with goods manufactured in Mexico, including those manufactured by the Mexican subsidiary of a foreign corporation. The effect of this policy on U.S. imports has not, so far, been great. Finally, there is a highly developed system of im- port agents who take responsibility for obtaining licenses and negotiating with foreign suppliers. The agents arrange for the import of a good and supply the ultimate end-user. Direct sales to end-users, al- though not rare, are not significant in volume when compared either to sales to import agents or those made directly to the Government. The medical devices market has also been affected by the foreign exchange difficulties that Mexico is cur- rently experiencing. In late 1982, exchange controls were placed on all foreign remittances from Mexican banks. These controls include Government approval of import contracts requiring payment outside of Mex- ico, even for purchases by Government agencies. Appendix J.— Glossary of Acronyms and Terms Glossary of Acronyms AAMI — Association for the Advancement of Medical Instrumentation AART — American Association of Respira- tory Therapists ACRS — Accelerated Cost Recovery System AFNOR — Association Francaise de Normali- sation ANSI — American National Standards Insti- tute, Inc. AOA — American Osteopathic Association ASTM — American Society for Testing and Materials BMD — Bureau of Medical Devices (Canada) BSI — British Standards Institution CABG — coronary artery bypass graft CAPD — continuous ambulatory peritoneal dialysis CCCN — Customs Cooperation Council No- menclature CDC — Centers for Disease Control (PHS) CEN — European Committee for Standard- ization CENELEC — European Committee for Electro- technical Standardization CFR — Code of Federal Regulations CHAMPUS — Civilian Health and Medical Pro- gram of the Uniformed Services CID — commercial item description CLIA — Clinical Laboratory Improvement Act CLMA — Contact Lens Manufacturers Asso- ciation CON — Certificate of need CPR — customary, prevailing, and rea- sonable CSA — Canadian Standards Association CT — computed tomography DEN — Device Experience Network (FDA) DHHS — Department of Health and Human Services DHSS — Department of Health and Social Security (United Kingdom) DIN — Deutsches Institut fur Normung DISC — Domestic International Sales Corp. DME — durable medical equipment DOC — Department of Commerce DRGs — diagnosis related groups ERTA — Economic Recovery Tax Act of 1981 ESRD FDA GAO GATT HCFA HIDI HIMA HMO IDE IEC IFAC IND Iv IPA IPPB IRS ISO ITA IUD JCAH JIS MEDIPP MITI NBS NCCLS NCI NFPA NHLBI NHS NIADDK NIH — end-stage renal disease — Food and Drug Administration (PHS, DHHS) — General Accounting Office (U.S. Congress) — General Agreement on Tariffs and Trade -— Health Care Financing Administra- tion (DHHS) — Health-Care Instrument and Device Institute — Health Industry Manufacturers’ Association — health maintenance organization — investigational device exemption — International Electrotechnical Com- mission — Industry Functional Advisory Committee (DOC) — investigational new drug — intravenous — individual practice association — intermittent positive pressure breathing — Internal Revenue Service — International Organization for Standardization — International Trade Administration (DOC) — intrauterine device — Joint Commission on Accreditation of Hospitals — Japanese Industrial Standards — Medical District Initiated Program Planning — Ministry of International Trade and Industry (Japan) — National Bureau of Standards (DOC) — National Committee on Clinical Laboratory Standards — National Cancer Institute (NIH) — National Fire Protection Asso- ciation — National Heart, Lung, and Blood Institute (NIH) — National Health Service (United Kingdom) — National Institute of Arthritis, Diabetes, Digestive, and Kidney Diseases (NIH) — National Institutes of Health (PHS, DHHS) 231 232 e Federal Policies and the Medical Devices Industry NMR — nuclear magnetic resonance NSF — National Science Foundation OEA — Office of Export Administration (DOC) OHTA — Office of Health Technology (PHS, DHHS) OIML — International Organization for Legal Metrology OMB — Office of Management and Budget OTA — Office of Technology Assessment (U.S. Congress) PHS — Public Health Service, DHHS PMAA — premarket approval application PRO — peer review organization PSRO — Professional Standards Review Or- ganization R&D — research and development Rehab R&D — Rehabilitation Research and Devel- opment SBIC — Small Business Investment Corp. SBIR — Small Business Innovation Research SIC — Standard Industrial Classification TEFRA — Tax Equity and Fiscal Responsibil- ~ ity Act of 1982 TUV — Technischer Uberwachungs Verein UCR — usual, customary, and reasonable charges UL — Underwriters Laboratories, Inc. U.S.C. — United States Code USTR — U.S. Trade Representative VA — Veterans Administration VAMKC — Veterans Administration Marketing Center VAREC — Veterans Administration Rehabili- tation Engineering Center VAT — value added tax VDE — Verband Deutscher Elektro- techniker WHO — World Health Organization YAG — yttrium aluminum garnet Glossary of Terms Applied research: Investigation whose objective is to gain knowledge or understanding necessary for determining the means by which a recognized and specific need may be met. Basic research: Original investigation whose objective is to gain fuller knowledge or understanding of the fundamental aspects of phenomena and of obser- vable facts without specific applications in mind. Capital costs: Expenditures for plant and equipment used in providing a service. Under Medicare's pro- spective hospital payment system established by the Social Security Amendments of 1983 (Public Law 98-21), hospitals’ capital costs (depreciation, inter- est, and return on equity to for-profit institutions) are treated as passthroughs (i.e., are not subject to the new system's controls). Certificate of need (CON): A State regulatory plan- ning mechanism encouraged by the National Health Planning and Resources Development Act (Public Law 93-641) to control expenditures for and distri- bution of expensive medical care facilities and equipment. CON applications are reviewed by local health systems agencies, which recommend ap- proval or disapproval to State health planning agencies. Class I: One of three regulatory classes set up by the 1976 Medical Device Amendments (Public Law 94- 295). Class I, general controls, contains devices for which general controls authorized by the act are suf- ficient to provide reasonable assurances of safety and effectiveness. Manufacturers of Class I devices must register their establishments and list their de- vices with the Food and Drug Administration (FDA), notify FDA before marketing a device, and conform to good manufacturing practices. Class II: The regulatory class of devices for which gen- eral controls are considered insufficient to assure safety and effectiveness and information exists to establish performance standards. Class III: The regulatory class of devices for which Class I general controls are insufficient to ensure safety and effectiveness, information does not ex- ist to establish performance standards, and the device supports life, prevents health impairment, or presents a potentially unreasonable risk of illness or injury. Conditions of participation: Requirements that a pro- vider must meet in order to be allowed to receive payments for Medicare patients. An example is the requirement that hospitals conduct utilization review. Development: Systematic use of the knowledge or un- derstanding gained from research in the design and development of prototypes and processes. Device type: All products of a particular type or a grouping of separate types of devices that are similar, as categorized by FDA. FDA has classified device types according to the potential risk posed by their use and the degree of regulation required. Diagnosis related groups (DRGs): Groupings of diag- nostic categories drawn from the International Classification of Diseases and modified by the pres- ence of a surgical procedure, patient age, presence or absence of significant comorbidities or complica- App. J—Glossary of Acronymns and Terms e 233 tions, and other relevant criteria. DRGs are the case-mix measure mandated for Medicare's prospec- tive hospital payment system by the Social Secu- rity Amendments of 1983 (Public Law 98-21). DRG payment: The system of prospective payment for inpatient services by Medicare which was mandated by the Social Security Amendments of 1983. Good manufacturing practices: Requirements regard- ing the manufacturing, packing, storage, and instal- lation of devices required under the Medical Device Amendments of 1976 and applicable to all three reg- ulatory classes of devices. Investigational device exemption (IDE): A regulatory category and process under which FDA permits lim- ited use of an unapproved medical device in con- trolled settings for the purpose of collecting data on safety and effectiveness. This information may subsequently be used in support of a premarketing approval application. Medical device: Any instrument, apparatus, or simi- lar or related article that is intended to prevent, diagnose, mitigate, or treat disease or to affect the structure or function of the body. Medical technology: The drugs, devices, and medical and surgical procedures used in medical care, and the organizational and support systems within which such care is provided. Nuclear magnetic resonance (NMR) imaging: A diag- nostic imaging modality that uses radiowaves and powerful magnetic fields rather than ionizing ra- diation. Orphan product: Defined by the Orphan Drug Act of 1983 (Public Law 97-414) as drugs and medical devices for rare diseases or conditions. Peer review organizations (PROs): Physician organi- zations established by the Tax Equity and Fiscal Responsibility Act of 1982 (Public Law 97-248) to replace Professional Standards Review Organiza- tions. Hospitals are mandated to contract with PROs to review quality of care and appropriate- ness of admissions and readmissions. PROs are also termed utilization and quality control peer review organizations. Postamendments device: A medical device first mar- keted after May 1, 1976, when the Medical Device Amendments took effect. Preamendments device: A medical device marketed before May 1, 1976, when the Medical Device Amendments took effect. Premarket approval application (PMAA): An applica- tion to FDA for approval to market a new device. The sponsor of the device must submit to FDA in- formation to document its safety and effectiveness before the drug may be marketed. Procedure (medical or surgical): A medical technol- ogy involving any combination of drugs, devices, and provider skills and abilities. Appendectomy, for example, may involve at least drugs (for anesthe- sia), monitoring devices, surgical devices, and the skilled actions of physicians, nurses, and support staff. Professional Standards Review Organizations (PSROs): Community-based, physician-directed, nonprofit agencies established under the Social Security Amend- ments of 1972 (Public Law 92-603) to monitor the quality and appropriateness of institutional health care provided to Medicare and Medicaid benefi- ciaries. Prospective payment: Payment for medical care on the basis of rates set in advance of the time period in which they apply. The unit of payment may vary from individual medical services to broader cate- gories, such as hospital case, episode of illness, or person (capitation). Standard Industrial Classification (SIC) codes: A cat- egorization of data on products and companies that is used by the U.S. Department of Commerce. Es- tablishments (plants) are assigned to SIC “indus- tries” on the basis of their primary line of business. 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Index American Association of Bioanalysts, 55 American Hospital Supply Corp., 29 American Osteopathic Association, 138 California, 66 Canada, 36 characteristics of the medical devices industry, 17-37 concentration, 28-31 diversity in products, 22 growth, 17-22 innovation, 31-35 changes in the clinical laboratory, 32 how ophthalmology has changed, 33 international competitiveness of U.S. medical devices, 35 manufacturers, 25-28 Congress: House Committee on Energy and Commerce, Subcom- mittee on Oversight and Investigations, 97, 105 Senate Committee on Veterans Affairs, 3 Senate Labor and Human Resources Committee, 3 consensus standards related to international trade, 204 Contact Lens Manufacturers Association (CLMA), 107 Cooper, Theodore, 98 database of Venture Economics, Inc., on sources of financial capital, 197 Department of Commerce, 22, 163 Department of Defense, 14 Department of Energy, 80 Department of Health and Human Services, 11, 49, 88 diagnosis related groups (DRGs), 7, 8, 48, 50 Dingell, Rep. John, 105 European Economic Community, 36 Food and Drug Administration (FDA), 3, 4, 5, 21, 44 classification of medical devices, 8, 103, 104, 105 investigational device exemption (IDE), 44 regulation of medical devices, 8-10, 97-133 General Accounting Office, 97 General Services Administration, 14 governmental regulation of international trade, 216 Health Care Financing Administration (HCFA), 44, 53, 60, 66, 138 Health Care Instrument and Device Institute (HIDI), New York, 91 health maintenance organizations (HMOs), 64, 65 Idaho, 144 IMS America, Ltd., 22, 29 Indiana, 48 innovative process in the medical devices field, 186-190 intermittent positive pressure breathing (IPPB), 45, 46 Internal Revenue Service (IRS), 21 Joint Commission on Accreditation of Hospitals, 138, 139 Japan, 36 Johnson & Johnson, 29 legislation: Drug Amendments of 1962, 97 Economic Recovery Act, 84 Employee Retirement Income Security Act, 84 Federal Food, Drug, and Cosmetic Act, 4, 5, 97 Medical Device Amendments of 1976, 3, 4, 5, 8, 9, 14, 44, 97 National Health Planning and Resources Development Act of 1974, 12, 138, 151 Omnibus Budget Reconciliation Act of 1980, 60, 66 Orphan Drug Act of 1983, 11, 88 Radiation Control for Health and Safety Act of 1968, 98 Small Business Innovation Development Act, 86 Social Security Amendments of 1983, 142 Louisiana, 144 Maryland, 48 Metatech Corp., 87 Minnesota, 144 National Institutes of Health (NIH), 5, 11, 79 National Science Foundation (NSF), 78 New Jersey, 48 New Mexico, 144 New York, 48, 91, 150 nuclear magnetic resonance (NMR) imaging, 82 patent policy regarding medical devices, 191-195 payment policies for health care and medical devices, 6, 41-73 financial relationship between the third-party payer and providers, 63-65 per capita payment systems, 64 public systems, 63 policy options, 65-73 hospital payment, 70 payment for devices used in the home, 67 payment for laboratory testing, 66 payment for physicians’ services, 68 systemwide reforms, 72 third-party coverage of medical devices, 43-45 third-party payment and the demand for medical devices, 45-63 hospital payment, 47 Medicare's DRG hospital payment system, 48 payment for ambulatory clinical laboratory services, 52 payment for durable medical equipment, 55 payment for home health care services, 59 parenteral and enteral nutrition therapy, 62 payment for medical devices used in the home, 54 257 258 ¢ Federal Policies and the Medical Devices Industry payment for physicians’ services, 51 Pharmaceutical Manufacturers Association, 31 Professional Standards Review Organizations (PSROs), 11, 12, 137, 140, 142 regulation by FDA, 97-133 discussion and conclusions, 117 impact of the amendments on medical device firms, 121 postmarketing controls, 120 regulation of intermediate classes of devices, 120 regulation of preamendments Class III devices and their postamendments equivalents, 118 scope of medical devices subject to regulation, 118 implementation of the medical device law, 102 classification of devices, 105 good manufacturing practices, 107 investigational device exemptions, 111 performance standards, 107 postmarketing surveillance, 114 premarket approval, 112 premarket notification, 103 reclassification of devices, 107 policy options, 126 assistance to small manufacturers, 132 postmarketing monitoring and controls, 132 regulation of Class II, or intermediate, devices, 131 regulation of preamendments devices and their postamendments equivalent, 128 scope of medical device regulation, 127 regulation of the providers of medical devices, 11, 137-154 Federal regulation, 137-145 health planning regulations, 143 under Medicare, 137 State regulation, 145-151 certificate-of-need laws (CON), 147-151 legislative activity in health planning, 1983 licensure of facilities and personnel, 145 research and development policies, 11, 77-94 Federal support for orphan devices, 88-90 wheelchairs, 90 policy options, 92-94 Small Business Innovation Research (SBIR) program, 86-88 sources of support, 79 U.S. GOVERNMENT PRINTING OFFICE : Federal support, 79, 81, 82, 83 private sources of funds, 80 State and local initiatives, 91-92 trends in medical devices R&D, 78-79 Small Business Innovation Research (SBIR) program, 11, 86-88 Standard Industrial Classification (SIC) codes, 17-30, 36, 37, 78 State certificate-of-need (CON) laws, 12, 13, 143, 144, 145, 147-154 tax policy and R&D, 199 U.S. Public Health Service, 14, 44 Veterans Administration (VA), 3, 4, 5, 6, 42 policies regarding medical devices, 13, 157-176 adoption and use, 169-172 influence of social, political, and economic fac- tors, 170 rehabilitative devices, 169 strategic planning, 171 discussion and policy options, 173-176 procurement, 174 research and development, 173 testing and evaluation, 173 overview of health care system, 157-160 veteran patient population, 158 procurement and supply, 166-169 central procurement by the VA marketing center, 166 procurement by VA medical centers, 168 research and development, 160-162 rehabilitation research and development service, 161 VA prosthetics center, 161 testing and evaluation, 162-166 commercially available equipment and supplies, 165 commercially available rehabilitative devices, 163 prototype rehabilitative devices, 162 VA Marketing Center, Hines, IL, 83 West Germany, 36 1984 0 - 25-406 \.C. 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