On June 7, the Federal Trade Commission (FTC) launched “an inquiry into the prescription drug middleman industry,” seeking documentation and records of business practices from the six largest pharmacy benefit managers (PBM). The goal is to examine if PBMs vertically integrated with insurers or pharmacies engage in anti-competitive practices and if these practices affect access to and affordability of prescription drugs.
The inquiry was in response to a request for information issued by FTC in February this year. Over 24,000 public comments were submitted. Much of the debate centers around rebates, restrictions on access, and the treatment of unaffiliated pharmacies.
There are three primary concerns over rebate practices:
- Since rebates are calculated as a percentage of list prices, PBMs are incentivized to place drugs with a high list price – instead of cost-effective ones such as generics or biosimilars – on preferred formulary tiers.
- In response to PBMs’ incentives, drug manufacturers increase list prices so that their products would obtain better formulary placement because PBMs would get a larger rebate.
- Consumers do not benefit from rebates because their cost-sharing is calculated based on list prices rather than post-rebate net prices.
Many solutions have been proposed in the last several years to regulate PBMs’ rebate practices, including those from academics, Congress, and the Trump administration, such as requiring rebates to be passed through to payers or consumers and replacing rebates with administrative fees.
However, research and economic reasoning suggest that regulating PBMs’ rebate practices will not shift rebate benefits from PBMs to payers or consumers, nor will it bend the cost curve. On the contrary, prohibiting rebates or fees linked to list prices and volume would increase prescription drug spending. See below why that is the case.
What does a PBM do?
PBM, a middleman as described by FTC, performs several key functions in the prescription drug supply chain. It negotiates drug prices with manufacturers, designs and manages formularies for payers (a formulary is a list of prescription drugs accessible to health plan members with various levels of cost-sharing), works with pharmacies to deliver drugs to patients, and processes prescription drug claims. PBMs may operate their own mail-order and specialty pharmacies.
Price negotiation with drug manufacturers and managing formularies have to go hand in hand because, without formularies, price negotiation would not be effective. Drug manufacturers compete with each other for favorable formulary placement by offering discounts in the form of rebates or fees.
But price negotiation and formulary management can be separated from contracting with pharmacies to deliver drugs and processing claims. Anthem’s contract with CVS Caremark is a case in point. CVS helps Anthem with prescription fulfillment and claims processing, but Anthem negotiates with drug manufacturers directly and manages its own formulary.
How do PBMs make money?
PBMs represent payers to negotiate prices with manufacturers and receive post-point-of-sale rebates or fees based on discounts off of list prices. A portion of rebates are passed through to payers, and PBMs keep the rest.
The second source of PBMs’ income comes from “spread pricing”, i.e., the difference between the amount they charge payers for prescription drugs and the amount they pay pharmacies.
Since PBMs provide services to payers and drug manufacturers, they collect administrative fees from them. PBMs also charge pharmacies direct and indirect remuneration fees based on performance measures.
In addition, PBMs derive revenue from operating their own mail-order or specialty pharmacies.
According to PBM Accountability Project, the industry earned a total gross profit of $28 billion in 2019, with $1.6 billion (6%) from retained rebates, $5.7 billion (20%) from manufacturer administrative fees – commonly calculated based on list prices and volume, $10 billion (36%) from operating affiliated mail-order or specialty pharmacies, and $10.7 billion (38%) from other sources including payer fees, revenue from spread pricing, and other revenue from pharmacies. (Note: Due to a lack of data, the report authors were not able to further disaggregate profits from “other sources.”)
How much value do PBMs generate?
As middlemen, PBMs have to provide value to both payers (e.g., plan sponsors and employers) by securing lower prices and drug manufacturers by realizing a larger sales volume.
The primary source of value generation is economies of scale because PBMs’ core business is essentially a volume discounting model. The more lives covered and pharmacies contracted, the greater their negotiation power, and the larger the sales volume. Of course, their know-how in and infrastructure for formulary management and claims processing play a role as well.
How much value do PBMs bring to the table? A recent study using multiple years of data on anti-cholesterol drugs demonstrates that PBMs reduce payments to drug manufacturers by 23% and save prescription drug costs by 18%, compared to a scenario where drug manufacturers sell directly to payers and consumers. Maybe by pure coincidence, a 2003 report by the U.S. Government Accountability Office estimates among federal government employees the same amount of savings (18%) that are attributable to PBMs.
Why regulating rebate practices won’t work?
PBMs’ core business is based on volume discounts. By offering concessions in prices, drug manufacturers compete for better formulary status and thus a larger sales volume. Therefore, any regulations limiting PBMs’ ability to leverage their economies of scale will kill value generation, just as surgeons are not allowed to perform surgeries using their hands.
As a result, part of compensation for PBMs must be linked to rebates or discounts obtained from drug manufacturers; otherwise, PBMs are not going to try their best to bring down the prices and every market player loses, including manufacturers, payers, and consumers.
Furthermore, the distribution of value created by PBMs – who gets a slice of the pie – depends on the market structure (i.e., the number of players and market shares). The more concentrated a market (fewer players and larger market shares), the larger slice of the pie. For example, if the PBM market is concentrated but the insurance market is not, much of the value will accrue to PBMs, and vice versa. If the insurance market becomes more competitive, a larger portion of the value will be captured by consumers.
It is also the case that if the market structure does not change, the allocation of value generated will not change barring heavy-handed regulations. Any attempt to change rebate practices will result in either shuffling dollars around or simply renaming revenue buckets.
With these as the backdrop, let’s look at several proposed solutions to the rebate “problem.”
Some proposed to require rebates to be fully passed through to payers. Under this scenario, PBMs could simply put the share of rebates belonging to them under “fees” charged to drug manufacturers, leaving the rest for payers. This seems consistent with what PBMs are doing. For instance, the proportion of commercial health plans contracting with Express Scripts and receiving full rebate pass-through increased from 50% in 2018 to 75% in 2021. For the industry as a whole, the rebates retained by PBMs decreased from $4 billion (13% of gross profit) in 2017 to $1.6 billion (6%) in 2019. But in the meantime, the fees from manufacturers – often linked to list prices and volume – increased from $3.8 billion (12%) to $5.7 billion (20%), more than offsetting the decline in retained rebates.
Proposals were also floated to mandate a full pass-through of rebates to consumers. This is not much different from a full pass-through to payers. Note that payers can simply increase premiums to offset reduced rebates. It is understandable that “protecting consumers’ interests” is a good selling point politically but not necessarily economically.
Another proposal is to replace rebates with discounts, with the goal to reduce consumer cost-sharing because co-pay and co-insurance would be calculated using net prices rather than list prices. It is ironic that rebates became popular after a class-action lawsuit filed by pharmacies alleging collusions among drug manufacturers in the 1990s. Manufacturers denied any wrongdoing but agreed not to charge differential prices to pharmacies vs. managed care organizations. In this case, assuming everything else is equal, the discounts would be smaller than the expected rebates because, with rebates gone, PBMs would need to increase the fees charged to manufacturers so that they are not worse off.
Replacing rebates with discounts is what the Trump administration aimed to achieve by revising the safe harbor rule to exclude rebates but allow point-of-sale price reductions; the rule was supposed to become effective in January 2022 but has been delayed till January 2026 as stipulated in the Infrastructure Act of 2021.
Finally, replacing rebates with administrative fees detached from list prices and volume was proposed by both academics and Congress. This is also part of the Trump administration’s plan. This approach would basically take the wind out of PBMs’ sails. If this were implemented and PBMs were not able to find another way to create value using their economies of scale, the prescription drug market would be less efficient and spending would increase.
Under this scenario, payers (maybe pharmacies too) would likely create a division to implement major PBM functions to directly negotiate with manufacturers and manage formularies, and current PBMs would perform the other two functions: prescription fulfillment and claims processing. But in this process, the market would lose the economies of scale leveraged by PBMs to keep prices down.
That being said, the likely outcome is that most market efficiency created by PBMs would be retained because it is challenging, if not impossible, to enforce the separation of PBMs’ compensation from discounts. For example, PBMs would receive an upfront “flat” fee from payers for the expected average discounts. Over time, both PBMs and payers would perfect their estimation of average discounts. PBMs would continue their practice of putting products with larger discounts on favorable formulary tiers because, technically, they would be rewarded for doing that.
But, how can we address the public’s concerns over rebates then?
Concern #1. PBMs are not incentivized to use cost-effective drugs such as generics or biosimilars and thus harm consumers’ well-being.
Remember, consumers are not PBMs’ clients; payers are. It is payers who should care about prescription drug spending and represent consumers’ interests. If payers cannot ensure formularies are properly designed to encourage the use of cost-effective drugs, it indicates that PBMs have overwhelming market power. For example, many payers are not able to put a clause in their contracts with PBMs to allow an independent audit.
The solution? We need to ensure a competitive PBM market. Unfortunately, the market is highly consolidated now, with the top three PBMs accounting for 80% of the total market. In addition, all major PBMs are vertically integrated with large commercial insurers and/or pharmacies.
Concern #2. Drug manufacturers increase list prices so that their products have better formulary status because PBMs can get a larger rebate.
The problem of increased list prices is associated with the drug manufacturer market rather than the PBM market – regulating rebate practices won’t address the issue. It depends on the number of manufacturers competing in a specific therapeutic area. If there is only one drug available, it is a monopoly, and there is not much PBMs or other market players can do. If it is a competitive therapeutic area, when one manufacturer increases its price, others can follow suit. As a result, there is no point in doing so because the first mover will not gain any advantage in competing for favorable formulary placement.
Again, the solution is to cultivate a competitive pharmaceutical market.
Concern #3. Consumers do not benefit from rebates because their cost-sharing is calculated based on list prices rather than post-rebate net prices.
As discussed in the previous section, we can force PBMs to pass through the rebates to consumers, but their insurance premiums would increase. Overall, there is little gain for consumers, if any at all.
The desirable way to protect consumers’ well-being is to make PBM and insurer markets more competitive so that a larger slice of the pie will be allocated to consumers.
Despite a public outcry over PBMs’ rebate practices, directly regulating rebates will not ensure that payers or consumers receive more benefits from rebates, nor will it bend the prescription drug cost curve.
The best way forward is to maintain and increase competition in the markets of drug manufacturers, PBMs, and payers.