Lewis Carroll and the Pricing of Pharmaceuticals – Pacific Research Institute

Lewis Carroll and the Pricing of Pharmaceuticals


Imagine a pharmaceutical market designed by Lewis Carroll’s Mad Hatter. In contrast to almost every other market, he might begin by charging wholesale prices that are higher than retail prices. He would then make sure that the higher wholesale price goes, the lower retail prices can become. And finally, he would ensure that not everyone could purchase their medicines at the low retail prices – although the reason why would be convoluted and random.

While we can be certain that the Mad Hatter did not design the current pharmaceutical pricing system, it is a system that he could surely appreciate.

The pricing process begins once manufacturers set a list price, from which Pharmacy Benefit Managers (PBMs) negotiate large discounts and rebates on behalf of insurance companies. Since the PBM negotiates down the list price of the medicine, the PBM claims a share of this savings for its efforts.

Offering PBMs a cut of the savings would make sense if they were effectively lowering the costs of medicines. But, the opposite appears to be happening due to PBMs control of the formularies (or lists of approved drugs) that payers use to decide which medicines are covered by insurance, and which medicines are not.

Leveraging this control of the formularies, PBMs, to a large extent, dictate the medicines patients can receive. Medicines in tier 1 of the formulary are generally covered; medicines in the other tiers are either more difficult to obtain, or are simply not covered. Most people have experienced, or know someone who has experienced, the consequences from this control – a patient cannot take the medicine prescribed by his or her doctor because the insurance does not cover it.

Manufacturers fear this coverage gap as well. Consequently, it is imperative for them to ensure that their medicines are listed in the first tier of the formulary; otherwise, sales will suffer. Since medicines are included in the first tier, in part, based on the size of the discounts offered by manufacturers, manufacturers are incented to offer the highest possible discounts on their medicines.

The capital costs of developing the medicine and the manufacturing costs of producing the medicine are not impacted by these pricing schemes, however. Therefore, large discounts can only occur when the list prices grow faster than otherwise, enabling larger discounts that bring the price of the medicine back to the intended transactions price.

PBMs encourage this convoluted scheme because they receive a share of the concession given up by the pharmaceutical industry. Put differently, PBMs receive more money due to the combination of high pharmaceutical list prices, offset by large discounts and rebates that lower the effective transactions prices. Some manufacturers also benefit by getting their products into first tier of the formulary, and thus able to sell their medicines. But, the health care system, overall, is less efficient.

For many manufacturers of lower-priced alternatives, they cannot sell their products at a cheap enough price to offset the revenues the complicated discounting scheme provides the PBMs and insurance companies. Thus, lower priced medicines (particularly for biosimilar medicines) are underperforming their potential.

Patients suffer in several ways. Financially, because their costs are based on these higher list prices, not the actual transactions prices, their costs are higher. Patients without insurance face even higher costs because they must purchase the medicines at the inflated list prices (uninsured patients do not have PBMs working on their behalf). Patient access to the clinically most effective medicine is also compromised, impacting their quality of care.

There are even more costs, however. Employers, and the government (both federal and state) suffer because they do not receive the full value of the discount, causing their costs to be higher than necessary.

These problems are then compounded because the rigidity created by the formulary tiers leads to volume-based discounts and exclusionary contracts that further lock-in the higher-priced medicines to the detriment of other competitive offerings.

The evolution of the current system demonstrates that complicated regulatory structures create overly-rigid market structures that lead to large, yet unintended, costs on the health care system. Effectively reforming this system should avoid layering on more complications in the vein hope that this Rube Goldberg can work.

Instead, the best way to reduce these unintended costs is to empower a vibrant competitive pharmaceutical market that: promotes more transparent pricing; empowers health professionals and patients to decide which medicines should be prescribed; and, incents manufacturers to offer patients a wider array of medicines, at lower costs.

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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.

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