Reforms Should Improve the Efficiency of the Pharmaceutical Market

Reforms Should Improve the Efficiency of the Pharmaceutical Market

The refrain that pharmaceuticals are driving the health care affordability problem has been repeated so often that it is becoming an illusory truth – people believe it to be true simply because they have heard it repeated so often.

Obviously, repeating the same incorrect statement over and over again does not make it so. It does squander valuable time as legislatures continually consider bills with no hope of improving the quality, or reducing the costs, of health care.

For instance, California is currently considering SB 17, a bill that would require pharmaceutical manufacturers to give a 60-day notice for any price increase above a certain threshold (generally a 16 percent list price increase).

This mandate would not only be costly, it is also unworkable because the price of medicines vary for many reasons, such as the differences in formulations, package sizes, doses, etc. Due to these complexities, much of the data collected under SB 17 would be difficult to interpret at best.

While the proposal claims that SB 17 will improve price transparency, price transparency will only improve when markets are empowered to operate efficiently. And, reams of government reports rarely improve market efficiency.

Instead of focusing on increasing regulatory mandates, reforms should fix the regulatory obstructions that are causing the sclerotic pricing system in the first place. Toward this end, it is important to understand how pricing in the pharmaceutical market works.

The regulatory environment has empowered pharmacy benefit managers (or PBMs) to serve as middleman who manage the drug benefits for insurance companies (i.e. manage the drug formularies, or lists of approved drugs), and negotiate price discounts with manufacturers. The top three PBMs now control prescription drug benefits for more than 260 million Americans.

Leveraging their control of the formularies, all sorts of market inefficiencies have arisen. Perhaps most importantly among these inefficiencies, the prices charged for pharmaceuticals are no longer reflective of the costs paid by the insurers.

The differences between the prices charged versus the costs paid are due to the manufacturer rebates and discounts that the PBMs negotiate on behalf of payers. PBMs’ revenues are based on the size of the discount they negotiate. When coupled with the opaque pricing system and the PBM’s large market share, these incentives have encouraged consistently large increases in pharmaceutical list prices that are then offset by ever growing rebates, discounts, and retroactive claw backs paid by pharmacists.

The growth in these offsets creates misinformation as the discrepancies between the growth in medicines’ list prices and the growth in the actual transactions prices have become quite large. For example, according to Express Scripts, one of the largest PBMs, list prices grew 10.7 percent in 2016, but transactions prices (the increased costs to their customers) grew a much smaller 2.5 percent.

Such discrepancies are not unique to Express Scripts either. According to a Berkeley Research Group (BRG) study, retrospective rebates and discounts accounted for nearly one-third of gross expenditures on branded pharmaceuticals in 2015.

Further, rebates’ and discounts’ share of revenues are growing at the expense of the manufacturers who actually produce the drugs for consumers, and the pharmacies who actually dispense the drugs to consumers. Put differently, the middlemen are getting bigger and richer at the expense of manufacturers and pharmacies.

These concerns were substantiated in a January, 2017 report from the Centers for Medicare & Medicaid Services (CMS). The CMS report found that the rebates that drug companies and pharmacies pay are growing, but it is the PBMs that are benefiting. The rebates are not lowering costs for patients or government health care programs.

PBM pricing vagueness also reduce the efficiency of the overall pharmaceutical market by rendering a drug’s actual list price almost meaningless. As a consequence, neither the patient nor the doctor knows how much is being spent when prescribing medications.

This compensation system also creates potential conflicts between a PBM’s financial interests (to push the medicines with the biggest discounts and rebates) and each beneficiary receiving the best medication from a clinical perspective. Since there is no PBM transparency however, there is no ability to evaluate these potential conflicts.

These are the problems that require legislative changes. Effective legislation will improve price transparency for patients and doctors, and empower pharmaceuticals to compete in an efficient market.

More broadly, instead of proposing symbolic legislation like California’s SB 17, effective health care reform must start the hard work of identifying the drivers behind the health care system’s adverse incentives, and proposing solutions that effectively eliminates them.

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Nothing contained in this blog is to be construed as necessarily reflecting the views of the Pacific Research Institute or as an attempt to thwart or aid the passage of any legislation.