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
Pharmaceutical manufacturers of brand-name drugs frequently charge different types of purchasers different prices for the same product.1 Such price dispersion occurs in markets where suppliers have some degree of market power and purchasers can be separated into groups that vary in their sensitivity to price. In the pharmaceutical industry, variation in price sensitivities across purchasers—combined with patent protection, a large R&D investment, and low production costs—often leads to a wide spectrum of prices for a given pharmaceutical product.
The Economics of Discounts
Manufacturers offer discounts on brand-name drugs based on both volume and the purchaser's ability to influence market share by systematically favoring one brand-name drug over another. Hospitals, clinics and health maintenance organizations that purchase drugs directly from manufacturers and influence the prescribing practices of doctors frequently pay less for the same product than retail pharmacies. For example, the Congressional Budget Office (CBO) found that hospitals pay on average 9 percent less than retail pharmacies while health maintenance organizations that buy directly from manufacturers pay on average 20 percent less than retail pharmacies, for top-selling outpatient drugs (CBO, July 1998).
It is the ability to move market share, not just the volume of drugs purchased, that leads to larger discounts and rebates. Many purchasers, including pharmacy benefit managers (PBMs)—companies that administer pharmaceutical benefits for health plans, HMOs and employers--receive rebates from manufacturers precisely because they apply a formulary to a broad patient base, something a retail pharmacy itself generally cannot do.2 Manufacturers give such rebates and discounts in exchange for being listed on a formulary--a list of drugs that is used to guide the prescribing practices of doctors. The more influence the purchaser wields in its ability to favor one brand-name drug over a similar competing drug, the higher the discounts and rebates can be. In a sense, this is price competition at work.3
Differences in price result because manufacturers apply typical profit-maximizing strategies based on the price sensitivity of buyers. According to economic theory, no purchaser pays a higher price to make up for the discounts offered to somebody else. Instead, each pays the price dictated by his or her price sensitivity.
The segment of the pharmaceutical market that negotiates for discounts has been growing over the last 15 years with the emergence of PBMs and the growth of managed care. Still, given that the size of discounts and quantity of drugs sold at a discount are not known, it is difficult to assess the extent of competition triggered by discounting.
Types of Manufacturer Discounts
Manufacturers' discounts on brand-name drugs take a variety of forms. The term "discount" is generally used when a lower purchase price is negotiated with the manufacturer.4 The term "rebate" is generally used when the manufacturer pays the purchaser an amount based on the volume of drugs purchased over a given period. The size of the rebate may also be tied to a percentage increase in volume, which demonstrates an ability to favor the manufacturer's drugs. For entities that never take possession of the drug, such as a PBM, rebates are the primary mechanism used. The result is the same--manufacturers sell their prescription drugs for a lower price, usually in exchange for an increase in volume.
Under this pricing scheme, those purchasers who are uninsured pay the most. In other words, in today's market for outpatient prescription drugs, people who have no insurance coverage for drugs, or third-party payers that do not use a formulary to manage their outpatient drug benefits, pay the highest prices for brand-name drugs. This includes some Medicare beneficiaries with drug coverage under Medigap as well as those who lack drug coverage altogether. Some policymakers have begun to address this issue by incorporating private sector purchasing techniques into proposals to extend a drug benefit to Medicare beneficiaries.
1This discussion draws partly on two CBO reports written by the author, How Increased Competition from Generic Drugs Has Affected Prices and Returns in the Pharmaceutical Industry, July 1998, and How the Medicaid Rebate on Prescription Drugs Affects Pricing in the Pharmaceutical Industry, January 1996.
2Formularies are also used to guide physicians toward less expensive drugs generally. Substituting generic drugs where possible, and using less expensive brand-name drugs as appropriate are as important for containing prescription drug costs as negotiating for rebates and discounts.
3When a variety of similar drugs are available, the purchaser has more opportunities to switch between drugs, creating leverage in price negotiations. Based on an analysis of the largest discounts offered to private sector purchasers, CBO found that those "best price discounts" were 12 to 17 percentage points greater when a generic drug was available. Interestingly, competition from similar brand-name drugs also significantly affected discounts. The best price discounts on brand-name drugs were 10 to 14 percentage points greater in therapeutic classes that had three or more similar brand-name drugs produced by competing manufacturers than in therapeutic classes with only one brand-name drug (CBO, 1998).
4Another important form of discounting involves the wholesaler. A charge-back may be used whereby the wholesaler delivers the drug at a discounted price, informs the manufacturer of the discounted delivery, and then is reimbursed by the manufacturer electronically.