With health-care costs running out of control, pharmacy benefit managers (PBMs), the companies that manage prescription drug benefits for 200 million Americans, are coming under increased scrutiny. The U.S. Office of Personnel Management, which operates the Federal Employees Health Benefits Program, has become the latest agency to announce it will be taking a closer look at PBMs.

On the surface, the issue involves who should get the money that PBMs generate. The PBMs sit at the center of a complex web of relationships. They get retail pharmacies to agree to discounted prices, negotiate rebates with drug manufacturers, and perform other tasks aimed at saving money. Since health plans hire the PBMs, they feel that nearly all the money should be passed through to them.

Often, however, PBMs keep the rebates they negotiate with drug companies and it apparently has become their primary source of revenue. Health plans are crying foul but they ultimately bear much of the responsibility. A flawed system of copayments, in addition to a federal Medicaid law, has brought about this state of affairs.

Copayments, or copays for short, are not a long-standing part of health benefit plans. They came into vogue during the managed-care revolution of the 1990s when HMOs sought to substitute prescription drugs and primary-care doctor visits for expensive hospital stays.

Copays are a flat dollar amount, as distinct from a coinsurance percentage. Today, a typical drug benefit might have a $10 copay for generic drugs and a $20 copay for brand-name drugs. By shielding consumers from the price differences between drugs, copays allow other factors, such as advertising, to have outsized influence on consumer preferences, and they do nothing to control costs. Health plans attempt to compensate for this flaw in benefit design by having PBMs administer drug formularies.

A formulary is a list of approved drugs that's determined by a committee. In theory, a formulary contains the drugs that are the most cost-effective – meaning a drug's efficacy is taken into account as well as its cost – thereby assisting clinical decision-making. But formulary committees "ignore individual differences in response to treatment and medicines," write Drs. Susan Horn, Frederick Goodwin, and Robert Goldberg in a paper published by the Heritage Foundation. Moreover, "the primary concern of such committees typically is neither the total cost of disease treatment, nor the long-term well-being of the patient, but rather the price and cost of the medicines."

The stronger this focus is, the more formularies increase the overall cost of health care. Dr. Horn led a research team that studied 13,000 patients from six HMOs and "found that more restrictive drug formularies were correlated with an increase in patients' use of more expensive medical services, treatment in emergency rooms and hospitals, and visits to doctors' offices."

Although copays and formularies are failing to control costs, many health plans have been refining this benefit design. The new wrinkle uses formularies as part of a three-tiered copay system. One example of such a benefit would be a $10 copay for generic drugs, a $20 copay for brand-name drugs on the formulary, and a $40 copay for non-formulary brand-name drugs.

This trend has been accompanied by a general rise in copay amounts. The immediate effect of higher copays is to shift costs from the insurer to the patient. But cost shifting is not the same as cost containment. A higher copay won't do anything to promote price competition and at best it will only temporarily restrain insurance costs. In its letter to the FEHBP plans, the OPM appears to understand this. "[Drug] Benefit incentives should support members who use their benefits wisely," it states, "rather than simply shift costs."

Because of the copay system, drug manufacturers don't attempt to earn consumers' business by reducing prices. Instead, they compete to get their drugs listed on formularies, which with a three-tiered benefit means a lower copay. The preferred method of getting on a formulary is to offer rebates to the PBMs. This is the consequence of a federal law that requires drug manufacturers to give state Medicaid programs the "best price" that they have offered any other plan. Thus, manufacturers have a built-in incentive to keep drug prices high, or else lose revenue on their Medicaid business.

The legality of formulary rebates is now being called into question by a compliance guide issued by the inspector general of the Department of Health and Human Services. The guide states, "Any rebates or other payments by drug manufacturers to PBMs that are based on, or otherwise related to, the PBM's customers' purchases potentially implicate the anti-kickback statute." For rebates to avoid anti-kickback violations requires "that the payments be authorized in advance by the PBM's customer [the health plan] and that all amounts actually paid to the PBM on account of the customer's purchases be disclosed in writing at least annually to the customer."

Such disclosure will obviously strengthen the position of health plans and allow them to get their hands on more of the rebates. But continued reliance on a system of copays, formularies and rebates won't make health-care costs any more affordable. Medicaid reform will be necessary to tackle the rebate issue. But private-sector plans looking to control their overall costs can act now and consign copays to the junkyard of health-care fads.

In their upcoming negotiations, the OPM should encourage FEHBP plans to abandon the use of copays and return to a coinsurance model or, even better, a new consumer-driven model that allows consumers to see the full price differences between drugs. Once consumers are armed with this knowledge, formularies can be given the boot and decisions now made by formulary committees can be returned to the doctor-patient relationship where they belong.

Chris Middleton is the Senior Policy Analyst for Health Care Studies at the Pacific Research Institute in San Francisco. He can be reached via email at cmiddleton@pacificresearch.org.

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