Report to the President: Prescription Drug Coverage, Spending, Utilization, and Prices.. Section 3.

While prescription drugs represent only about seven percent of total national health expenditures, in absolute dollars the market is formidable (Copeland, 1999). In 1998, the prescription drug market represented over $91 billion for approximately 2.5 billion prescriptions at the retail level. The average prescription cost increased 11.9 percent over the prior year (Glaser, 1999). Projections of U.S. retail spending on prescription drugs forecast expenditure levels of $103 billion in 1999 and $143 billion by 2002 (Sager, 1999). Increases in total drug spending are concentrated in a relatively small number of therapeutic categories. Four drug categories account for 30.8 percent of the total $42.7 billion increase in drug spending between 1993 and 1998: antihistamines, antidepressants, cholesterol lowering agents, and anti-ulcerant drugs. (Barents, 1999).

Growth in drug spending is generally associated with two primary factors: (1) higher drug prices; and (2) increased demand for drugs (Smith, 1999). High drug prices account for about 64 percent of the total 1993-98 increase in drug spending (Barents, 1999). This is largely due to the recent flood of new and more costly drugs into the market following revisions in the Food and Drug Administration (FDA) procedures to accelerate the drug approval process. In 1998, the average price per prescription for a new drug was $71.49, which is twice the average ($30.47) for previously available drugs. Forecasters expect a slowdown in these introductions as the industry’s drug development pipeline stabilizes to the new regulatory timelines (Smith 1999).

Increases in the number of drugs that patients use are largely attributed to the drop in out-of-pocket costs, resulting from greater prescription coverage through managed care plans and, until recently, a deceleration in drug price inflation (Smith 1999). Another influence is the change in FDA policy in 1997 (and finalized in 1999) to allow pharmaceutical manufacturers a freer hand in advertising directly to consumers through mass media. In 1998, pharmaceutical manufacturers spent $8.3 billion promoting their products, of which $1.3 billion was in direct-to-consumer advertising (Barents, 1999).

Providing prescription drugs to patients involves an intricate, multifaceted system of drug distribution that includes a number of players such as pharmaceutical manufacturers, wholesalers, retailers, third-party administrators, pharmacy benefit management companies, managed care organizations, and providers. Each of these players participates in the pricing of drugs as either purchasers (who try to reduce their outlays) or providers (who try to maximize profits). The following section summarizes these roles.

While every facet of the drug distribution system attracts attention, pharmaceutical manufacturers tend to attract an inordinate amount because perception holds them as the most profitable link in the distribution chain. At the manufacturer level, there are two major distinctions in product lines: 1) brand name drugs and, 2) generic drugs. Typically, innovator companies who carry the burden of research and development costs that are factored into the prices of marketable products develop brand name drugs. Estimates of the cost of bringing a new drug to market range from $125 million to $500 million. In 1998, pharmaceutical companies spent over $17 billion in research and development (PhRMA, 1998). The costs are, as a rule, borne during the drug development process and recouped after market approval during the time when the patent is still in place. In 1998, the median approval time for a new drug application was 12 months for a New Drug Application and 12 months for a new molecular entity (NME) (CDER, 1998). Research-intensive manufacturers generally try to price their products so that the bulk of research and development costs are recovered before competitors enter the market.

When a patent expires on a brand name prescription product, other manufacturers may enter the market and produce generic equivalents of that particular product. A generic equivalent is essentially a drug that is chemically identical to the brand name drug and is also bioequivalent. Generic pharmaceutical companies invest far less research and development monies to gain FDA approval for marketing their products. A generic manufacturer conducts only one or two bioequivalency studies before entering the market. These studies must demonstrate within certain statistical parameters that the generic version of the drug is absorbed into a patients blood stream at approximately the same rate and duration of time as the brand name drug (CDER, 1998).

Unlike the pricing practices of the brand name manufacturer industry, the generic industry prices its products as another commodity trying to gain market share through lower prices. Generics offer one of the earliest and most frequently used methods of containing costs. Since generic drugs are usually more price sensitive to the market than brand name drugs, generic drugs are often required by third-party programs. It is important to note the program does not necessarily care whether patients receive a brand name drug as long as the price is no greater than that of the generic drug.

Nearly all of major research-intensive brand name manufacturers, numbering approximately 100, are members of the trade association, Pharmaceutical Research and Manufacturers of America, known as PhRMA. PhRMA reported that the domestic U.S. sales of its members were $81 billion in 1998 (PhRMA 1998). In contrast, the generic industry reported sales of $8 billion in 1998 (GPIA, 1998).

Not surprisingly, the marketing techniques of brand name and generic manufacturers differ considerably. Brand name manufacturers tend to focus their marketing strategies primarily on physicians, who will potentially prescribe their products, while the generic manufacturers focus on the purchasers, e.g. pharmacies and hospitals. Since generic drugs tend to be less expensive than brand name drugs, they are as a rule preferred by insurance programs and other third-party payers and even required when available for reimbursement. There are exceptions to this rule, however, such as when a large purchaser may negotiate a brand name price that is competitive if not less expensive than the generic alternative.

Drug wholesalers operate as the middlemen between the drug manufacturers and the retail pharmacy. The wholesaler provides a very useful function to both independent and chain pharmacies because it buys in very large amounts and then distributes in small allotments. This relieves the pharmacy from the burden of dealing with each individual manufacture for every purchase (Smith, 1975). In most cases, wholesalers also provide products within 24 hours, which helps the pharmacy maintain a less costly inventory.

Over the past few years, the wholesale drug industry has become quite concentrated. While there are still a number of wholesalers in operation, the top five wholesalers account for 90 percent of the entire wholesale drug market. (NWDA, 1999) In 1998, the net sales of prescription drugs by wholesalers were 57 billion dollars. Such concentrated purchasing allows these few pivotal entities much influence over drug pricing at this juncture in the distribution chain.

The retail level of the distribution chain includes independent and chain pharmacies, supermarket pharmacies, mail order houses and Internet web-based pharmacies. There are approximately 50,000 independent and chain pharmacies in the United States. In the current market, the number of chain pharmacies is increasing as independents are being purchased by multi-store pharmacies. Chain pharmacies have recently undergone a period of consolidation and now the market power of the surviving chains is considerable. The ability to move large market shares of drug products allows chain pharmacies to command volume discounts from manufacturers and to contract directly with managed care organizations for exclusive distribution rights. The chains are also in a position to negotiate favorable rates with managed care organizations that need the chains in order to serve a geographically dispersed member population.

To reinforce the concept that prescription drugs at the retail level are commodities, it is important to note the eroding gross margins of pharmacies. Gross margins have dropped from a high point of approximately 40 percent to a low point of about 16 percent between 1996 and 1998 (NCP, 1998; Carroll, 1996). Many pharmacies, especially the smaller ones, cannot stay in business within the narrow gross margins permitted by third-party reimbursement programs. One study documented a gross margin decrease of 26.9 percent following the change in one insurance company’s reimbursement formula which caused the pharmacy a net loss on every prescription dispensed for members of that plan (Ganther, 1999).

Retail pharmacies use a variety of methods to control costs and maximize gross margin. One mechanism is to participate in a network of pharmacies to provide services to members of contracted health plans. The pharmacies in a network sign contracts agreeing to comply with the health plans' rules and regulations and to accept the reimbursement levels offered by the plan (Hejna, 1995). Membership in a network allows a pharmacy to participate in third-party reimbursement programs but this does not guarantee a reasonable reimbursement rate. Thus, pharmacies use other mechanisms to control their costs in obtaining prescription drugs. These include joining a buying group where the pharmacies consolidate market power to buy products with volume discounts. Some buying groups maintain warehouses of drug products and distribute them to the pharmacy members of the group as a way to reduce costs.

Internet pharmacies are a new phenomenon so their influence on drug prices is still largely unknown. It is interesting to note that they use mail order to distribute their products and thus are members of the mail order pharmacies’ professional organization, the Pharmaceutical Care Management Association (PCMA). Mail order pharmacy accounts for about 12 percent of the total retail prescription market. Between 1997 and 1998 mail service pharmacy grew by 19 percent (Anon., American Druggist, 1999). This compares to the total prescription market, which grew by 18.5 percent (Glaser, 1999). The proportion of the market accounted for by mail order pharmacy continues to grow at a small annual rate. Internet pharmacies, in addition to providing prescription drugs, provide a wide array of other drug related products such as over the counter medications, some cosmetic products, etc. Both mail order and Internet pharmacies must be licensed and comply with the same level of regulation as any traditional pharmacy establishment. In addition, the mail order pharmacies must also generally register with the states where they mail medications.

Mail order pharmacy is commonly included in prescription drug programs because mail order pharmacies can offer prescription drugs at a discounted price. This is because of the volume of their drug purchases and economies of scale. Patients in plans with mail order options are often provided financial incentives for using this type of pharmacy. These incentives may include discounted or forgiven copayments.

Third party programs in pharmacy cover a variety of players. The third-party is an entity other than the patient or pharmacist who is paying for all or part of the prescriptions. These include insurance companies, third party administrators (TPAs), state Medicaid programs, large employers, and managed care organizations. Third party drug programs provide a wide range of activities. These include claims processing, drug use review, formulary administration (which may include rebates) and disease management programs. TPAs are responsible for processing claims and conducting drug utilization review to ensure the quality of the program. However, TPAs are not financially at risk for any of the payments as are insurance companies or other programs (Gardner, 1986). To capture the growth in third-party programs, it is instructive to note that in 1968, perhaps five percent of prescriptions were paid for by some third-party, whereas in 1999 that figure is closer to 70 percent (Lyles, 1999). This growth includes all types of third-party programs, including insurance programs where an insurance company or other payer for the prescription drugs they would purchase may merely indemnify a patient.

The widespread use of computers in pharmacy practice has made it extremely easy for a plethora of third-party programs to exist and operate seamlessly within a particular practice setting. Typically, the pharmacist enters information into the computer on each patient and dispensed drug. The information is routed through a computerized network as a claim for the product cost and dispensing fee to the patient's third-party plan. Each third-party plan’s system has algorithms or reimbursement rules for coverage, eligibility, deductibles, pricing of the prescription, patient cost-sharing such as copayments, and therapeutic issues such as drug duplication or drug-drug interactions. The third-party plan’s system responds back within minutes with information on potential drug interaction alerts, copayments amounts required from the patient and reimbursement approvals. The plan's computer system may be maintained by the plan themselves, by insurance companies, by third-party administrators or by pharmacy benefit management companies (PBMs).

Pharmacy benefit managers (PBMs) are relatively new to the prescription drug arena and yet they now control a substantial part of the prescription drug market. PBMs act as intermediaries between pharmacists, patients, employers, managed care organizations, and third-party payers. According to Copeland, there are approximately 40 PBMs in the United States with the top five accounting for more than 75 percent of the market (Copeland, 1999). The U.S. General Accounting Office has issued at least two critical reports focusing on PBMs. The first GAO study addresses alliances between PBMs and pharmaceutical manufacturers. Several manufacturers own or legally participate in business alliances with PBMs, which has caused concern over whether this constitutes unfair competition. The theory behind this concern is that if a manufacturer owns a PBM then that manufacturer’s products might appear on the PBM’s formulary in an unfair manner and to the exclusion of other manufacturers’ products. The results of this particular report were not definitive enough to conclude that there was unfair competition (GAO, 1995). The second GAO study examined whether the Federal Employees Health Benefits Program (FEHBP) was satisfied with savings and services related to pharmacy benefit managers. The three FEHBP plans that they studied had contracted with PBMs to manage pharmacy benefit payments. The PBMs did save the plans a substantial amount of money, however the study notes that the plans' decision to use PBMs can shift business away from retail pharmacies to mail-order pharmacies (GAO, 1997). In addition to bias issues, HMO concerns about PBMs include confidentiality of data, disclosure of information to patients, and the HMO’s own oversight of the performance of PBMs (Office of Inspector General, 1997). Despite concerns, PBMs continue to be a dominant force in the prescription drug arena: PBMs currently serve over 150 million patients annually (PCMA, 1999).

As alluded to in one of the GAO reports, the PBMs have substantial relationships with the retail pharmacy sector. While the PBMs negotiate with drug manufacturers on the one hand, on the other hand they must assure adequate sites for patients enrolled in the various plans to obtain their prescription drugs. Therefore, they contract with retail pharmacies to provide this service as well as process claims and provide payment to the pharmacies. Obviously, the PBM will optimize its position by obtaining the widest geographic pharmacy coverage while keeping costs at their lowest. Chain pharmacies, with their considerable market power are able to negotiate more profitably (for them) arrangements with PBMs than are independent pharmacies that do not have the market share or geographic coverage of the chains. Because of this, relationships between independent pharmacies and PBMs are often quite strained (Ganther, 1999; Carroll, 1996).

One important way that PMBs control costs is through formularies. A formulary is a list that the plan uses to make reimbursement decisions about individual drugs. The formulary may be open or closed. An open formulary usually means that the plan will cover all drugs except those listed as exclusions to the drug reimbursement policy. A closed formulary details the specific drugs that meet the plan’s reimbursement policy. Preferred formularies impose lower copayment amounts for formulary drugs versus non-formulary drugs. Ideally, formularies are constructed with two primary considerations, first clinical and then cost (Grabowski, 1997). Restrictive formularies have been the subject of few peer reviewed research articles and the results are mixed. Horn (Horn, et al., 1996) suggested that restrictive formularies may result in increased costs and lower quality care while Walser et al. (1996) concluded that restrictive formularies might be more beneficial. Ideally, the list of covered drugs should first be based on sound clinical considerations after which cost should be taken into account. However, as Schulman (1996) has demonstrated, some PBMs report that the primary consideration is cost followed by clinical.

The pricing for prescription drugs is complex and varies greatly depending on who is the payer and who is the seller. The following is a summary of three major measures of prescription prices: the Producer Price Index, the Average Wholesale Price and the retail pharmacy charge.

The Producer Price Index (PPI) for pharmaceutical drugs measures inflation at the earlier stage of the production and marketing process. It is based on the prices of almost 50 therapeutic classes and indicates the prices paid at the wholesale level. The PPI is often used to determine whether the annual growth rate in drug prices exceeds those of other goods and services. The pharmaceutical manufacturer industry has long criticized the PPI as not properly assessing the impact of new medicines and thus overstating true drug inflation. (PhRMA, 1995)

The average wholesale price of a prescription drug (AWP) is undoubtedly the best known of the pricing terms. It is comparable to a sticker price on an automobile where the manufacturer suggests a certain price but almost everyone pays something different from that price. It tends to be a reliable price reference for brand name drugs but can be misleading with generic drugs since each manufacturer establishes its own AWP for the same product (Cohen, 1995). It is very important to have some reference point for pricing, negotiations, reimbursement, etc., and AWP serves effectively in this role. Unfortunately, the AWP does not really capture actual transaction prices including discounts and rebates (Schweitzer, 1997). The average wholesale price is referenced to some extent in most Medicaid and other third-party programs, but it is virtually unheard of for a plan of any size to pay AWP without extracting some discount from the retailer. Historically, pharmacists used AWP as their basis for pricing. However, they would usually purchase the drugs from wholesalers or manufacturers at some percentage discount from AWP and could thus retain the difference between what they paid for the drug and the cost basis for reimbursement as additional profit. As drugs became more of a commodity at the retail level, third-party payers including Medicaid programs and others, sought to share if not completely capture this "additional" profit. In effect, this substantially eroded the gross margins of pharmacies and thereby created friction between pharmacies and PBMs or other third-party payers. Using state Medicaid programs as an example, some states would reimburse pharmacists at AWP minus 10 percent plus a dispensing fee that varies depending upon the state. The AWP compares to the average manufacturer price (AMP) which is defined as the average price paid by wholesalers for products distributed to retailers (Cohen, 1995). This is obviously one step removed from the retail sector. This term gained widespread public notice with the passage of OBRA 90 where it was used as the reference point for calculating the rebates that drug manufacturers would have to provide to state Medicaid programs (NPC, 1998). Today, it is still used as the primary reference point for determining drug rebates in a variety of prescription drug plans.

The most common method of pricing in a retail pharmacy is to start with a cost basis for the drug and then add a pharmacy-dispensing fee to arrive at a selling price. For mechanical purposes, let us assume that an AWP for a particular prescription is $100 and the dispensing fee is $3. If there were no discounts from AWP included in this particular example, the prescription would be priced at $103. If the pharmacist paid AWP for this product then the pharmacist would gross $3 on that particular prescription. Now let us assume that the pharmacist is being reimbursed at AWP minus ten percent plus the $3 dispensing fee. In this case, the drug cost would be $100 dollars minus $10 (ten percent) or $90. Adding the dispensing fee of $3, the reimbursement price for this particular prescription would be $93. In this case, the pharmacist would need to be able to purchase the product for at least AWP minus 10 percent.

Retail prescription charges are frequently quoted in the lay press but they are difficult to interpret across different types of pharmacies. Drug Topics reports the average value per prescription-drugstore acquisition cost for 1998 at $36.79 per prescription (Glaser, 1999). For 1997, this cost is reported as $32.87 (Gebhart, 1998). However, the average prescription charge for 1997 for independent pharmacies ranged from $24.97 to $34.44 depending on overall sales volume, and was actually higher for pharmacies with high third party activity (NCPA, 1998). A Consumer Reports survey examined retail prices for five commonly prescribed drugs at 26 pharmacies, including chains, independents, supermarkets, mass merchandisers and online/mail order. In general, online pharmacies provided the best prices and independent the highest, although the authors note that the extra service provided by independent pharmacies may be worth it (Consumer Reports, 1999). In general, individual consumers pay more out-of-pocket for prescription drugs than do other more favored purchasers such as HMOs or the federal government (Bettehheim, 1999). The marketplace, as it currently exists, has created a wide range of prices for the exact same product.

One of the thorniest issues surrounding prescription drug prices is rebates. When a PBM is considering adding to or deleting drugs from the formulary, it will negotiate with individual drug manufacturers about providing incentives since the inclusion or exclusion will ultimately mean large dollars to the manufacturer. Generally, these incentives constitute a manufacturer’s rebate calculated as a percentage of the product that flows through the PBM to the plan. The rebate is often set in advance and based on the market share that a manufacturer expects to see for its product within a plan. As an example, assume that a manufacturer and PBM agree that sales of drug X for one year, at average manufacturer price (AMP), will be $5 million. Based on this, the manufacturer agrees to “rebate” back to the PBM 10 percent of the AMP for products dispensed though the particular plan represented by the PBM. The PBM would ultimately receive $500,000 from the manufacturer. The PBM, which is acting on behalf of a client such as a large employer, would receive some of this as a fee for services and the remainder remitted back to the client. The concept of a drug rebate was first widely applied when Congress passed the Omnibus Budget Reconciliation Act of 1990 (OBRA 1990) requiring drug manufacturers to provide rebates back to State Medicaid programs (NPC, 1998). Rebates have revolutionized the prescription drug marketplace. In 1994, rebates to all Medicaid programs totaled $1.8 billion out of total Medicaid outpatient drug payments of $9.5 billion (Lyles, 1999).

Rebates do not directly affect the retail sector, per se. While rebates have a substantial effect on the overall cost of drugs to a particular program, they are negotiated between the manufacturer and PBM or other third-party payer. Thus, when pharmacists dispense a prescription drug to a patient, they are essentially ignorant of any rebate arrangements made for that particular product. This is not to say that the retail sector is totally unaffected. For example, if a plan were not able to obtain the percentage rebates necessary to operate profitably, it may attempt to extract additional from the retail sector.