Most noninstitutionalized people, regardless of their coverage status, obtain prescription drugs through some form of retail pharmacy, including independent pharmacies, chains, pharmacies in supermarkets or mass merchandisers, and mail-order pharmacies. In 1998, sales through retail outlets accounted for 90 percent of total outpatient prescription drug sales (excluding sales to hospitals and long-term care facilities or agencies).1
The following description of this system will begin with the simplest series of transactions, those that culminate in a retail purchase by a consumer who pays for a prescription in full at the point of sale. Some of these customers, referred to as cash customers in this chapter, may file a claim with their insurer for reimbursement after the transaction. This description will be followed by a summary of how prices are established for private insurers and PBMs, along with a review of the special pricing systems for Medicaid, the VA, and certain other favored purchasers.
The prices paid by these various types of customers are illustrated in Table 3-1, which portrays illustrative pricing for brand name drugs. The prices in the table are based on a composite of commonly prescribed brand name drugs and reflect documented relationships among the prices for different transactions.2 Ranges of prices are included where more precise information, particularly on drug rebates, cannot be documented. Actual price relationships vary substantially by drug, and are quite different for generic drugs. Generic drugs, for example, have much lower prices on average and the fixed costs for the pharmacy of dispensing the prescription represent a much higher proportion of the final retail price. Furthermore, approaches to pricing generic drugs in the industry are different.
The share of purchasers who pay in full at the time of the transaction (referred to as cash customers) has been steadily decreasing in recent years. This category includes both those with no insurance coverage for drugs and those with indemnity coverage who file claims after the retail transaction is complete. In 1990, 63 percent of retail prescriptions involved cash customers, while 37 percent involved billing by the pharmacy to third-party payers or Medicaid (Figure 3-1). By 1998, only 25 percent of prescriptions were paid for by cash customers.3
Figure 3-1. Payment Sources for Prescription Drug Purchases, 1990-1998
Source: IMS Health Retail Method-of-Payment ReportTM, 1999.
This trend does not represent a growth of coverage as much as it represents a shift in how drug coverage works. During the 1990s, the common approach has shifted from indemnity coverage to coverage that is managed at the point of sale.
With indemnity insurance, a customer typically pays cash for the full cost of the prescription at the pharmacy and then files a claim for reimbursement from the insurer. As noted in Chapter 1, most people with private group coverage for prescription drugs have some form of managed drug benefit, administered by a PBM or sometimes directly by an HMO or other insurer. Under PBM administration, point of sale transactions are now the norm. Under such a transaction, the pharmacist uses a computer system to determine the deductible, copayment, or coinsurance, which the customer pays at the retail counter.
Management of drug benefits has become the norm for group coverage. For nongroup coverage, including Medigap, it is much less common. In the case of Medigap, for example, the insurer's liability is limited to half of total spending between a deductible and a cap; insurers generally have not seen enough potential for savings to invest in benefit management.
As noted previously, the ultimate prices paid for prescription drugs by or on behalf of consumers are established through an intricate system involving pharmaceutical manufacturers, wholesalers, retailers, and insurers or other managers of drug benefits. Accordingly, the descriptions below, despite the apparent level of detail provided, are necessarily simplified in order to convey the key characteristics of this system.
Pricing for Cash Customers
Cash customers at retail pharmacies include people without coverage and people with indemnity coverage who pay for their own prescriptions and are later reimbursed by their insurer.4 Prices are set by a series of transactions linking the manufacturer to the cash customer through the wholesaler and the retail pharmacy, as shown in Table 3-1.
Sale by Manufacturer to Wholesaler
In the first transaction, the manufacturer sells the drug to a wholesaler. The manufacturer establishes a price that varies by the form and strength of the product; for example, a 500 milligram tablet of a given drug will have a different price from a 250 milligram tablet of the same drug. Price may also vary by packaging; for example, a package containing 1,000 tablets of a given medication might have a lower price per tablet than a package of 500 tablets. When there is only a single manufacturer of a drug, as is often the case with a brand-name drug, there is only one price for a specific product and package size. Once generic versions of the drug become available, the equivalent medication (in form, strength, and package) may be offered at different prices by different manufacturers.5
Wholesalers may sometimes receive discounts from manufacturers, based on volume or prompt payment. A manufacturer of a multi-source drug (i.e., one that is produced by more than one manufacturer) may offer a discount to induce wholesalers to promote its particular version of the drug. Thus the manufacturer's price is only a guideline, and may not represent the price that all wholesalers ultimately pay for the drug. The manufacturer's price itself represents both the cost of producing the drug and a share of the manufacturer's research and development costs, taxes, and profits. For any particular drug, the price may reflect the market position of the drug more than the cost of its production; for example, a company may set a higher price for an innovator drug than for one which has several competitors. Further breakdown of these components of the manufacturer's price is outside the scope of this study.
Sale by Wholesaler to Retail Pharmacy
In the second transaction, the wholesaler sells the drug to a retail pharmacy at a price reflecting its cost of acquiring the drug plus a markup. This price may be referred to as the wholesale price or acquisition price. A price that is commonly cited in the industry is the "average wholesale price," or AWP. Despite what this name would suggest, the AWP is not the average of the amounts actually paid by retail pharmacies to wholesalers for a particular drug. Instead it is a published wholesale price or "list price" suggested by the manufacturer of the drug. A wholesaler may sell specific drugs to all pharmacies at prices below the AWP, or may grant a general discount to certain pharmacies. Thus, although the AWP is often used by pharmacies as a cost basis for pricing purposes, it does not represent the actual cost to a retail pharmacy of acquiring the drug. It is merely a wholesale list price that can be used as a benchmark in comparing retail and wholesale prices.6
Industry sources suggest that the price charged by the manufacturer to the wholesaler typically runs about 20 percent below the list price or AWP. In the example in Table 3-1, the acquisition price (paid by the pharmacy to the wholesaler) is $9 below the AWP. The markup added by the wholesaler is generally small, perhaps 2 percent to 4 percent.
Sale by Retail Pharmacy to the Consumer
In the third transaction, the pharmacy sells the drug to a consumer at a price that includes its cost for acquiring the drug from the wholesaler plus a retail markup. Part of this markup is a fixed cost that is not related to the cost of acquiring a specific drug. This is because the cost to the pharmacy of filling a prescription for a low-price drug is likely to be the same as for a high-price drug. As a result, the fixed cost is a higher percentage markup over acquisition cost for a low-price drug than for a high-price one. Different pharmacies have different fixed costs. Because of economies of scale, a large chain pharmacy may have lower costs than a small independent one.
Part of the markup varies by drug. Pharmacies employ a variety of pricing strategies when determining this markup for their sales to cash customers. For example, they may set a lower markup for maintenance medications and a higher markup for acute medications, or may routinely discount certain commonly used medications as "loss leaders," in order to attract cash customers who will then buy other medications or other merchandise.
Some industry sources have suggested that retail markups in the range of 20 percent to 25 percent over the pharmacy's acquisition price are typical. This markup includes both the fixed operating costs of the pharmacy as well as taxes and profits. These same sources also suggest that the fixed costs represent most of this markup amount. In the example in Table 3-1, the $52 cash price is 4 percent above the AWP. The pharmacy in this example includes a retail markup of about 25 percent over its acquisition cost in the price charged to its cash customers.
Pharmacies may also offer across-the-board discounts on drugs to certain groups of cash customers, such as senior citizens. In addition, some organizations negotiate discounts on behalf of people without drug coverage or people who pay cash because their coverage is an indemnity plan. For example, AARP offers its members a Member Choice Program operated by RPS, Inc. In return for a $15 annual fee, members receive access to discounts negotiated with pharmacies by RPS. AARP reports that members receive average discounts of $7.26 per prescription or about $160 per year. Some insurers that sell both indemnity coverage and coverage that pays pharmacies directly may offer their indemnity purchasers access to the discounts they have negotiated on behalf of their other enrollees. This is true of United Health Care, which sells Medigap coverage through AARP, and of some Blue Cross/Blue Shield Medigap plans. These various discounts are part of the average prices cited later in this chapter.
Pricing for Insurers and Pharmacy Benefit Managers
The simple pricing model just described applies to cash transactions but not to those in which the retail pharmacy is paid by a group insurer, employer, or other third party at the point of sale. This section will describe mechanisms affecting the prices paid by private third parties that manage drug benefits. Again, because management by a PBM is most common, this term will be used as a shorthand for all private entities managing drug benefits.7
Because a PBM may manage the drug benefit for a large number of individuals, it can negotiate discounts at both ends of the pricing chain: from the manufacturer and from the retail pharmacy. There is little published data about the size of the discounts obtained by PBMs and private insurers, either from manufacturers or from retailers. Discounts from retailers will be estimated later in this chapter, using the MEPS and IMS Health data. Manufacturer rebates are not reflected in these data sources. Rebate agreements are highly confidential and most information about them derives from anecdotes.
The price paid to a retail pharmacy for a given drug is negotiated by the PBM and the pharmacy or pharmacy chain. Typically the PBM will take into account its estimate of the cost to the pharmacy of acquiring the drug (usually assuming that the pharmacy has paid something less than the AWP) and offer a dispensing fee above that amount. This dispensing fee is commonly a fixed dollar add-on (in the range of $2.50) that is not related to the cost of acquiring a specific drug.8 Because some PBMs cover a large share of the market, a pharmacy will often accept a price that is less than it would charge to cash customers. The PBM's negotiating power may be offset, however, by its need to assure that its enrollees have access to convenient pharmacies. It might offer a higher price to a large chain than to scattered independent pharmacies.9
Discussions with industry experts conducted during the preparation of this report have provided current information on typical PBM payments to retailers. These experts estimate that payments for brand-name drugs are in the range of AWP minus 13 to 15 percent, plus a $2.50 dispensing fee. (The range from 13 to 15 percent depends primarily on how restricted the pharmacy network is.) The example in Table 3-1 illustrates this type of discount, resulting in a price that is lower than that faced by cash customers but in this case still offers a 12 percent markup over the pharmacy's acquisition price. For some drugs, however, a pharmacy may be forced to accept reimbursement from the PBM that does not cover the pharmacy's cost of acquiring the drug (let alone its operating costs). The PBM has considerable leverage in this relationship, especially as the proportion of drugs sold through PBM-managed arrangements grows (Figure 3-1). The pharmacy is left with an option of refusing the large share of business, raising its prices for cash customers, or reducing its operating margin.
For generic drugs, about three-fourths are reimbursed using limits known as maximum allowable cost (MAC). These limits are established by PBMs, based on the lowest estimated acquisition cost for any of the generic equivalents of a given drug. The MAC tends to be 50 to 60 percent below AWP. The remaining one-fourth of generics are reportedly reimbursed, like brand-name drugs, at AWP minus 13 to 15 percent. The dispensing fee for generics tends to be the same as for brand drugs, but sometimes it is 25 or 50 cents higher, to encourage generic substitution by pharmacies.
The second type of discount that the PBM gets is a negotiated rebate paid directly from the manufacturer to the PBM. This rebate does not affect the price paid by a wholesaler to a manufacturer for the drug, the price paid by a retail pharmacy to the wholesaler, or the price paid by the PBM to the pharmacy. It is a separate transaction between the PBM and the manufacturer and thus affects the total amount spent by the PBM. To the extent that a portion of the rebate is passed along, the insurer, employer, or beneficiary may realize a part of these savings.
A key tool in determining whether rebates are available and how large they are is the use of a restrictive formulary, a list of drugs that the PBM has established as preferred for its enrollees. If there are multiple brand-name drugs available for a given condition, the PBM may include some on its formulary and not others. Enrollees who obtain a non-formulary drug may pay higher copayments, or the drug may not be covered at all. Pharmacies dealing with the PBM may be encouraged to contact physicians who have prescribed non-formulary drugs and suggest a formulary alternative.10 Physicians affiliated with the health plan using the PBM may also face pressure to prescribe formulary drugs. In addition, PBMs will commonly require or encourage substitution of generic equivalents for brand-name drugs when these are available. Again, they may charge higher copayments for brand name drugs, or limit reimbursement to the generic price even when the brand-name drug has been dispensed.
Manufacturers of brand-name drugs that treat conditions for which an alternative brand-name treatment is available thus have a strong incentive to grant discounts to the PBM in return for the inclusion of their drugs in the formulary. If generic equivalents are available, the manufacturer may also grant a discount to make the price of its brand-name product more competitive. These discounts usually take the form of direct rebates from the manufacturer to the PBM. For example, in the simplest rebate arrangement, the PBM may report periodically to a manufacturer the number of prescriptions for a given drug that the PBM's enrollees have filled; the manufacturer then pays the PBM an agreed-upon amount for each prescription. In addition or as an alternative to a per-prescription rebate, manufacturers and PBMs also negotiate arrangements where the PBM is reimbursed for moving market share -- causing a significant increase in the number of prescriptions for the manufacturer's drug.
One study by the General Accounting Office attempted to quantify the value of rebates obtained by PBMs contracting with plans participating in the Federal Employees Health Benefits Program (FEHBP). Blue Cross/Blue Shield paid about $1.4 billion for FEHBP pharmacy benefits in 1995 and estimated that its PBM had saved $505 million, of which 21.2 percent was attributable to manufacturer discounts or rebates and 52.3 percent to discounts from retail and mail-order pharmacies.11 If costs in the absence of the PBM would have been $1.9 billion, this suggests retail or mail-order discounts of 14 percent (consistent with the estimates cited above) and manufacturer rebates of 5 to 6 percent (or slightly more, assuming the PBM did not pass all rebates fully to Blue Cross). Overall FEHBP plans estimated that their savings from manufacturer rebates ranged from 2 to 21 percent of total savings. Industry representatives report that rebate savings can be much higher (35 percent) on selected drugs.12
Table 3-1 uses a range of rebate amounts to show the net effect on the price if the unmeasured rebates were taken into account. This amounts to a hypothetical retail price of $30 to $44 (compared to the total $46 price that the pharmacy receives from the customer and the insurer) if the discounts were applied at the pharmacy instead of through rebates to the PBMs. An alternative way to display this discount would be to reduce the manufacturer's price by the rebate or by some portion of it. Because rebates cannot be measured, the analysis reported later in the chapter does not reflect this additional discount.
PBMs that operate under contract to an insurer or self-insured employer are required to pass on most of the rebates. Industry sources report that the insurer or employer typically receives 70 to 90 percent of the rebates. In addition, the PBM will often guarantee a minimum per-prescription rebate, in case actual rebates received from manufacturers are lower than expected. While estimates differ, industry experts report that the value of rebates passed on to insurers or employers may average about $1.00 per claim.13
In addition to cash rebates, industry analysts have reported that PBMs may receive noncash benefits from manufacturers or cash rebates that are not tied to a particular drug. For example, PBMs may receive rebates from manufacturers in return for agreements with regard to the content of their communications with physicians about the use of certain drugs (sometimes called counter-detailing). PBMs that operate their own mail-order pharmacies may receive extra discounts on drugs purchased by those pharmacies. Other PBMs may receive support for development of disease management systems or other research activities. Some industry analysts believe that the value of these other considerations may exceed the amount of cash rebates. The PBM may not be obligated to pass these benefits on to plan sponsors.
Finally, a PBM can realize further savings by encouraging enrollees to use a mail-order pharmacy. (Some PBMs operate their own mail-order pharmacies.) Enrollees may pay a lower copayment when using a mail-order pharmacy or may be required to use mail-order for drugs to be taken over a long period, such as maintenance drugs for chronic conditions. Mail-order pharmacies can operate with a smaller markup than other retail pharmacies, because of economies of scale and lower overhead. They may also be more successful in encouraging prescribing physicians to agree to substitute formulary for non-formulary drugs, because they have more time to contact a physician before filling a prescription.
Pricing for Favored Private Purchasers (HMOs and Hospitals)
Not all drugs dispensed by pharmacies are purchased from wholesalers. Institutions that operate their own outpatient pharmacies, such as hospitals and clinics, may deal directly with manufacturers, either individually or through buying groups. They typically save the wholesaler markup. In addition, they may receive a price lower than that offered by the manufacturer to wholesalers. Table 3-2 shows estimates by the Congressional Budget Office, based on IMS data, of the discounts received by these purchasers, which represent a total of about 14 percent of the market. These discounts are reported relative to the average acquisition price paid by retail pharmacies, excluding mail order, in 1994.
Rebates and other discounts that do not appear on an invoice are not included in the price relationships reported in this analysis. Because of their direct purchasing relationship with manufacturers, however, these entities are less dependent on rebates based on the amount of a particular drug dispensed. It appears that rebates play a smaller role for these purchasers than for PBMs that do not purchase drugs directly. More complete pricing data are unavailable.
The estimate for HMOs in Table 3-2 reflects discounts to the relatively few HMOs, such as some of the Kaiser Permanente plans and other staff or group-model HMOs, that operate their own pharmacies and buy drugs directly from manufacturers. This is not an estimate of the size of rebates that are received by the majority of HMOs, which manage drug costs and utilization through PBMs and whose enrollees obtain their prescriptions through retail outlets.
In Table 3-1, the HMO price is $34, based on the relationship reported by CBO (Table 3-2) and confirmed by other information obtained from industry sources. There is evidence that some HMOs obtain at least some drugs at prices substantially below the price in this illustration. Recently, the HHS Inspector General reported on two HMOs that were able to purchase a drug at prices considerably below the reported best price for that drug.14
Pricing for Federal Facilities and Agencies
Prices paid to manufacturers by the VA, other federal agencies, and certain other entities, such as Indian tribal governments, are set by the Federal Supply Schedule (FSS). Under the Veterans Health Care Act of 1992, manufacturers must make drugs available to covered entities at the FSS price as a condition of eligibility for Medicaid reimbursement.
FSS prices are negotiated with manufacturers by the VA.15 In general, the FSS price may be no higher than the lowest contractual price charged by the manufacturer to any nonfederal purchaser under similar terms and conditions. In order to determine this price, manufacturers supply the VA with information on price discounts and rebates offered to different customers and the terms and conditions involved. Under certain conditions, the VA may accept an FSS price that is higher than the price offered to some nonfederal customers. According to the GAO, average FSS prices are more than 50 percent below the nonfederal average manufacturer's price.16 This result is somewhat lower than the relationship shown in Table 3-2 based on the CBO study.
For certain drugs sold to the VA, the Department of Defense, the Public Health Service, and the Coast Guard, the manufacturer must charge the lesser of the FSS or a "federal ceiling price."17 The federal ceiling price is set at 76 percent of the average manufacturer's price; this limit may be higher or lower than the FSS. The rule applies only to brand name drugs without competition or innovator multiple-source drugs.18
In the example in Table 3-1, the federal supply schedule price of $24 is about 60 percent of the manufacturer's price and well under the various retail prices charged to different types of customers. Not surprisingly, it is fairly close to the $30 that represents the lowest price that might be achieved by insurers and PBMs (and Medicaid) in cases where they get the largest manufacturer rebates. This makes sense for a "best contractual price" standard. If the table could represent the full range of prices achieved by some buyers for some drugs, there would probably be cases where other third parties achieved prices below this FSS price.
More generally, the fact the FSS price is generally lower than other prices may have a variety of explanations. These include the small share of the market that federal purchasers represent (less than 2 percent), the effectiveness of the VA as a price negotiator, and the interest that manufacturers may have in making sure their drugs are available to federal facilities and agencies (including VA hospitals that train a large number of physicians).
Pricing for Medicaid Programs
Medicaid programs pay retail pharmacies using fixed cost limits and fixed dispensing fees. For single-source drugs (brand-name drugs without generic equivalents), the cost limit is set at the estimated pharmacy acquisition cost for the drug. For multiple-source drugs (with brand name or generic competitors), the limit is based on a MAC. These are similar in concept to the MACs used by PBMs; some PBMs may simply use the Medicaid MACs, while others develop their own. The Medicaid MACs are published by HCFA(now known as CMS) every six months and are set at 150 percent of the lowest published price for any equivalent drug, plus a dispensing fee.19
Under provisions of the Omnibus Budget Reconciliation Act of 1990, Medicaid programs receive rebates from manufacturers.20 Participation is generally required for a manufacturer's drugs to be eligible for Medicaid reimbursement. For single source drugs and innovator multiple-source drugs, the rebate must equal the difference between the average manufacturer price (AMP) - the average paid by wholesalers - and the manufacturer's "best price." The best price is the lowest price offered by the manufacturer to any purchaser at any time during the year, excluding the special prices for federal purchasers and certain other covered entities.21 The minimum rebate must be 15.1 percent of the AMP. For non-innovator multiple source drugs, the rebate is 11 percent of the AMP; the best price concept does not apply.
In Table 3-1, Medicaid reimburses the retail pharmacy for its acquisition price plus a dispensing fee. As noted, states obtain a minimum 15.1 percent rebate, corresponding to a net effective price of $37. Average rebates are in the range of 21 percent, which would yield an ultimate price of $34, but may range higher for certain drugs.