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Pricing Mechanisms Used by the Federal Government to Contain Prescription Drug Costs

Anna Cook, Ph.D.
Mathematica Policy Research, Inc.

A memorandum prepared for the Department of Health and Human Services’ Conference on Pharmaceutical Pricing Practices, Utilization and Costs

August 8-9, 2000

Leavey Conference Center, Georgetown University

Washington, DC

Final Version

The federal government employs a variety of mechanisms to contain prescription drug costs including Medicaid's rebate program and the Federal Supply Schedule (FSS) of prices. This memorandum describes these cost containment mechanisms and discusses some of the benefits and limitations of the mechanisms in terms of their impact on nonfederal purchasers and their ability to contain costs in the long term.

The Medicaid Rebate Program

The Medicaid rebate program, established by the Omnibus Budget Reconciliation Act of 1990, has helped to contain government spending on outpatient prescription drugs. In 1996, the rebate reduced total Medicaid drug expenditures from $11 to $9 billion. The federal government and the states share Medicaid expenditures as well as the rebate savings.1 States reimburse pharmacists directly for drugs purchased by Medicaid beneficiaries and then report their expenditures to the federal government for partial reimbursement.

Under the basic rebate formula, pharmaceutical manufacturers pay a rebate equal to at least 15.1 percent of the average price they earn on sales to retail pharmacies for brand-name drugs purchased by Medicaid beneficiaries. The basic rebate is often higher than that 15.1 percent minimum because of a "best-price" provision that gives Medicaid access to the lowest price paid by any private purchaser in the United States.

The best-price provision increases the Medicaid rebate when a manufacturer gives a discount that exceeds the minimum rebate of 15.1 percent. In such cases, the Medicaid rebate is equal to the largest reported discount given to any private sector purchaser. Since Medicaid constitutes about 12 percent of the outpatient prescription drug market, pharmaceutical manufacturers are less willing to give large private purchasers steep discounts because they are required to give Medicaid access to the same low price. The Congressional Budget Office has documented how the size of the largest discounts offered on many brand-name drugs shrunk as a result of this provision.2

As a result of the best-price provision, those private purchasers that get access to steep discounts potentially pay more for some brand-name drugs. CBO has estimated that purchasers would have to receive a discount of roughly 1/3 off the list price before the best price provision could potentially limit their discounts.3 The quantity of drugs sold at the best price is not known. Therefore, it is difficult to assess the magnitude of the effect of the change in pricing on private sector purchasers. Clearly, though, the provision hurts purchasers with access to the largest discounts.

If a brand-name drug=s average price to pharmacies rises faster than the inflation rate, an additional rebate is imposed so that manufacturers cannot offset the basic rebate by raising their prices.4

The additional rebate combined with Medicaid=s basic rebate gives manufacturers an incentive to charge a somewhat higher launch price for a new drug than they would in the absence of the Medicaid rebate program. The larger Medicaid=s anticipated share in total sales of a drug, the greater is the effect.

Federal Supply Schedule Prices

The Federal Supply Schedule (FSS), which is administered by the Department of Veterans Affairs, is a catalogue of prices; it includes pharmaceutical prices. Federal government purchases from the FSS totaled about $1.3 billion in 1996.5 Manufacturers have certain incentives to give large price concessions on the FSS schedule. For example, many physicians receive part of their training at VA hospitals, and manufacturers may want to make sure that these new physicians learn about their prescription drugs.6 Greatly expanding access to the FSS of prices could cause those prices to rise. For example, the FSS prices rose somewhat during the brief period in which the Medicaid program had access to those prices.7

Policy Implications

The ability of the Medicaid rebate to contain costs is limited somewhat in the long term because manufacturers can charge higher launch prices for new drugs to partially offset the Medicaid rebate. In addition, promoting the use of more cost-effective drugs is as important as obtaining lower prices. While the Medicaid program has been successful in promoting generic substitution, it has few mechanisms to promote the use of more cost effective brand-name drugs. Some states are addressing this issue individually, by experimenting, for example, with prior authorization programs (requiring permission be obtained before the pharmacist can dispense certain drugs).

When considering cost containment mechanisms that might be used for a large share of the market (such as Medicare beneficiaries who constitute over one-third of the outpatient market for prescription drugs) it is also important to consider how those mechanisms will affect pricing for nonfederal purchasers.

1Certain Public Health Service grantees and disproportionate share hospitals also have access to the manufacturer prices available through Medicaid=s rebate program. One study has estimated that purchases by such entities came to just over $1 billion in 1997 (Cook and Dong, An Analysis of Purchases, Savings and Participation in the PHS Drug Pricing Program, Mathematica Policy Research, September 1999).

2Congressional Budget Office, How the Medicaid Rebate on Prescription Drugs Affects Pricing in the Pharmaceutical Industry, January 1996.

3CBO found that the average manufacturer price on which the Medicaid rebate is based averages about 80 percent of the manufacturer list price (also known as the average wholesale price or AWP). So if AWP = $1.00 per pill, then a purchaser would have to be paying less than roughly (.8)($1.00)(1-0.151) = 68 cents per pill before the best-price provision is likely to take affect (on average). Since the average manufacturer price on which the Medicaid rebate is based is not public information, purchasers do not know for sure whether their discounts exceed the minimum rebate.

4The additional rebate is equal to the difference between the current AMP and a base-year AMP increased by the inflation rate as measured by the consumer price index.

5General Accounting Office, Drug Prices: Effects of Opening Federal Supply Schedule for Pharmaceuticals Are Uncertain, June 1997 (GAO/HEHS-97-60).

6The Veterans Administration, Department of Defense and the Public Health Service never pay more than the federal ceiling price, even if the FSS price of a brand-name is higher. The federal ceiling price is equal to at least 24 percent off of the average price that manufacturers charge to non-federal purchasers.

7General Accounting Office, Medicaid: Changes in Drug Prices Paid by VA and DOD Since Enactment of Rebate Provisions, GAO/HRD-91-139 (September 1991).