Fostering Transparency In The Pharmaceutical Market


In response to the problem of rising list prices for drugs, elected officials continue to propose counterproductive reforms. Whether it is importing drugs from Canada or indexing U.S. drug prices to the prices charged in other countries, these policies will make the current bad situation worse because they fail to understand the disincentives that are the root cause of the problem.

Until now.

A proposal by Health and Human Services Secretary Alex Azar, if implemented, would meaningfully improve the pharmaceutical market. The details get complex quickly, but at its core Secretary Azar’s proposal recognizes that the solution requires the government to fix the broken price system. The price system has been broken by the complexity created by our current third-party payer system.

Thanks to the current system, there are multiple prices paid when a patient receives a drug. Simplifying this system, when a patient buys a medicine, her cost is based on the list price of the drug. So, if the list price of a drug is $100 and a patient has a $0 co-pay but 20% co-insurance, then she would pay $20 when receiving the drug.

While it might seem logical that the costs to insurers would then be $80, this is not how the system works. Instead pharmacy benefit managers (PBMs) have negotiated discounts on behalf of insurers. These discounts reduce the list price, on average, by 44%. Therefore, the cost for insurers is based off of this price, the net price, which would be $56 in this example, not the $100 from which patients’ costs are calculated.

While patients’ costs are based on the higher list prices, the income of manufacturers and the costs of insurers are based on the lower net prices. PBMs use the large spread between list prices and net prices to generate their fees and rebates. In fact, since PBMs’ revenues are based on the spread, they have an incentive for list prices to grow as fast as possible in order to enable a larger spread and, thus, higher profits.

The actual pricing behavior has been consistent with these incentives, in part due to the PBMs control over the drug formularies, which are the insurers’ list of approved drugs. The consequence has been fast growing list prices (which harms patients), but slow growing net prices, in order to create the largest possible discounts to the system. Further, the system favors higher-priced drugs (such as originator biologics rather than lower-priced biosimilars) because higher-priced drugs enable larger discounts.

In recognition of these perverse incentives, Secretary Azar has proposed reforms that would fundamentally change the pricing incentives of the industry. Currently, there are safe harbor protections (a protection against legal liabilities or penalties) on the rebates that manufacturers pay PBMs. Under the proposed reform, these safe harbor protections will be “expressly excluded” for any rebates paid to the PBMs, but will be granted when discounts are offered to “patients at the pharmacy counter”. Due to these changes, the discounts and rebates will cease being paid to the PBMs for Medicare Part D plans and Medicaid managed care plans, and will instead go directly to patients.

By eliminating the discounts and rebates that are hidden from patients, and ensuring that the patients directly benefit from all discounts offered, the proposal will significantly improve price transparency in the pharmaceutical market. By itself, this greater transparency is a large improvement to the pricing system.

It is also important that the costs for patients comes down. Under the proposal, patients will not only directly receive the discounts, helping to lower their costs, the incentive for list prices to unnecessarily increase will be eliminated as well. Of course, the net impact for consumers will depend upon what happens to premiums and other charges, but by dis-incenting higher-priced drugs and creating a more transparent pricing structure, it is likely that the proposal will effectively “bend the cost curve”.

The same is true for the government. While actuaries are still finalizing their estimates, the results of a Milliman study has found that when the improved systemic incentives are fully considered, the expenditures of the federal government will decrease. Thus, fears that the proposal will lead to higher overall government expenditures are speculative.

While beneficial, by definition, the HHS proposal is limited in scope. To apply these benefits more broadly requires Congressional action. Further, while the proposal is an important step, it is not sufficient. Additional reforms are necessary to continue improving the efficiency of the pharmaceutical market.

Compared to the other proposals that have been offered, Secretary Azar’s proposed reform is unique because it properly diagnosed one of the problems ailing the pharmaceutical market and then suggested reforms that corrected it. His proposal is, consequently, a beneficial reform worth implementing.

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.

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