GP Kidd—Getty Images/Cultura RF
By Shawn Tully
February 5, 2019

On January 31, the Trump Administration unveiled a long-awaited plan to outlaw controversial rebates that drugmakers pay to pharmacy benefit managers and plan sponsors that negotiate drug prices on behalf of federal programs. Those rebates are supposed to lower the prices that health plans charge their patients––and the Administration swears that the those tens in billions in cash aren’t benefiting folks who get their prescriptions filled at the corner pharmacy counters or delivered by mail. As part of the announcement, the Department of Health and Human Services issued a “Fact Sheet” that declared in Trumpian rhetoric, “This proposal has the potential to be the most sweeping change to how Americans’ drugs are priced at the pharmacy counter, ever, by delivering discounts directly to patients a the pharmacy counter, and bringing much needed transparency to a broken system.”

The system is indeed broken, but the Administration is ignoring the right prescription. The principal reason that it’s so tough to drive down drug costs is a mostly-overlooked, blatantly anticompetitive regulation that blocks private purchasers from securing the super-deep discounts they’d be garnering in an open market. The barrier is known as the “Medicaid Best Price” policy. In effect, it puts a concrete floor under prices offered to the private plans that purchase over 40% of America’s prescription drugs. The HHS release advertises itself as a daring manifesto for taming drug prices, yet makes no mention of this competition-killer. The best RX: Let freedom ring, and scuttle Best Price.

To be fair, the Trump proposal, as formulated by HHS, contains valuable reforms. Today, beneficiaries covered by Medicare Part D, the program for seniors that’s provided mainly through plans administered by the PBMs, are charged deductibles and co-pays based on the official “list” price for prescription drugs, which don’t include the big rebates to the PBMs and insurers. The new reform package would eliminate the rebates, and mandate that PBMs replace those rebates with discounts that they’d offer directly to their customers at their neighborhood CVS pharmacy counter, or on the Express Scripts price list. Hence, patients would pay out-of-pocket charges based on the real, net price paid by Medicare and private insurers, not on the much higher list price.

It’s not clear, however, that the new policy of requiring direct discounts to consumers will be any more effective at curbing overall drug inflation than today’s system of rebates.

Substituting discounts for rebates may amount to claiming that you get a better deal when your credit card gives you 3% off on everything you buy instead of 3% cash back on the same purchases. The principal objective should be removing any restrictions that limit the PBMs, HMOs and other purchasers’ ability to wrest the absolute best prices, however they’re packaged. And that’s where the Medicaid Best Price policy poses a roadblock that will prevent the Trump Administration from delivering on one of its most heavily touted goals.

It’s important to understand that the new rules are primarily aimed at Medicare Part D, the program that accounts for around around 30% of the $500 billion the U.S. spent on drugs in 2018. The measure wouldn’t outlaw rebates to PBMs managing private plans. It also leaves the Medicaid Best Price policy precisely in its current form. The 123 page full text of the proposed regulation states, that “the proposed rule would not alter obligations for Medicaid prescription drug rebates…including provisions related to best price.”

The new plan undermines its avowed goal of arresting drug price inflation in two ways, the first in failing to reform Best Price, and the second in risking that its new crusade, by outlawing rebates, will axe the PBMs’ strongest tool for clinching the best deals, an unintended consequence similar to the fallout from Best Price. To be sure, Medicaid is a much smaller program than Part D, accounting for 11% of all prescription drug spending. But as we’ll see, the Best Price provision effectively caps discounts not just for Medicaid, but all private providers––and those HMOs, hospitals, and insurance plans comprise over two-fifths of the market, meaning that all told, Best Price handicaps the players that pay more than half of America’s yearly bill for prescription drugs.

Second, the new rules take aim at the PBMs’ policy of trading market share for deep discounts or rebates. That’s how competition is supposed to benefit consumers, whether it’s packaged goods companies offering bargains in return for extra shelf space for their detergents or chipmakers granting special breaks to reign as a PC-maker’s principal supplier. But in its proposal, HHS objects that “manufacturers pay PBMs that meet certain volume-based or market-share criteria,” adding that “the use of rebates creates a financial incentive to make formulary decisions based on rebate potential, not the quality or effectiveness of the drug.” In effect, HHS is arguing that when a PBM offers a manufacturer a 70% market share with a payer in exchange for a deep discount, the beneficiaries actually pay higher prices at the pharmacy because the PBMs favor drugs with super-high list prices, so that the net price their customers pay exceeds the pre-rebate price. According HHS, the PBMs are pocketing a big chunk of the rebates for themselves, and providing no real discounts at all to customers. The new rules call for rebates to be reclassified as illegal “kickbacks.”

The HHS view is highly questionable. The PBMs compete aggressively for market share, and the big plans should be choosing a PBM based on the net prices, or highest rebates, it can wrest from the drug companies. HHS favors discounts that are offered directly to beneficiaries at point-of-sale, but it’s unclear if the PBMs will be able to generate discounts equivalent to the rebates their now getting. That’s because the HHS seems poised to restrict their freedom to trade a top place on a big payer’s formulary for a sharp reductions in price. It’s interesting that the pharmaceutical industry is applauding the new rules.

Susan Cantrell, chief executive of Academy of Managed Care Pharmacy, the industry association that represents PBMs and other health care providers that manage medications for 270 million Americans, makes a telling point: “The Administration’s plan would take away an important lever that health plans use to negotiate rebates, and lower prices,” Cantrell told Fortune. “What would replace the rebates? The assumption seems to be that the manufacturers will automatically lower their costs to consumers.”

The damage inflicted by the Best Price rule should prove a warning to the Administration. This reporter covered how the now 28-year old regulation hobbled competition shortly after it was introduced, and does so to this day. It’s informative to understand the rule was the brainchild of Big Pharma, and was specifically designed by the industry to prevent the deep discounting that was then threatening its members’ profitability.

In the late 1980s, the pharmaceutical industry was getting hit hard by a cast of new power players, pharmacy benefit managers. The PBMs concentrated the purchasing clout of large numbers of private health plans by negotiating prices on their behalf. Manufacturers had launched sundry competing beta blockers, ace inhibitors and other therapies that though patented and based on slightly different chemistry, produced identical results in treating patients. The PBMs capitalized on this multiplication of competing medications by driving deep discounts. For example, a PBM could get a manufacturer to slice 50% from the list price of its beta blocker (a therapy that lessens stress on the heart) by granting the drug the leading place on its plans’ formularies, and steering the vast bulk of its patients’ purchases to that top choice. It was a classic game of handing a producer the lion’s share of the market in exchange for a steep cut in price.

That trend caused widespread alarm in Big Pharma. Around 1990, an industry legend––F. Roy Vagelos, CEO of Merck––found what was from his industry’s viewpoint a diabolically clever solution. He proposed that drugmakers grant a large fixed discount to the behemoth that was for many their largest customer, Medicaid. As part of the deal, if a manufacturer offered a deeper reduction than the Medicaid rebate to any private HMO or health plan, it was obligated to provide that super-low price to Medicaid as well. The offer sounded great to lawmakers. Why shouldn’t our government, their biggest customer, get the best deal from Big Pharma?

In 1990, Congress adopted Big Pharma’s prize proposal, what’s now known as the Medicaid “Best Price” policy. In its first phase, Best Price granted a 12.5% flat rebate on the vast bulk of prescription drugs covered by Medicaid. In exchange, Medicaid agreed to offer all of each participating manufacturers’ medications to enrollees. That meant sacrificing its ability to secure even sharper discounts by directing extra business to bargain-priced drugs. It did require higher copays for pricey therapies when a similar substitute was available at a lower price. Still, Medicaid–the program that provides healthcare to over 70 million low-income and disabled Americans––grants heavy subsidies even for the priciest pharmaceuticals. It current role as a store that provides shelf space for Big Pharma’s every offering is the price it pays for across-the-board discount first proposed by Vagelos.

Shortly after the legislation was enacted, Vagelos boasted publicly that he’d found, and sold, the fix for stopping the deep discounts to private plans that were threatening Big Pharma. The bragging was a rare misstep by Vagelos, and made the PBM managers furious––but he’d scored an historic success in handcuffing the buyers poised hammer prices for years to come.

The minimum rebate rose to 15.1% in 1995, then jumped again 23.1% when the 2009 Affordable Care Act expanded Medicaid coverage to an additional 16 million enrollees. Drug manufacturers serving Medicaid sign national agreements with HHS to provide the minimum rebate to all Medicaid plans, in all 50 states. The major manufacturers have to participate; unless it agrees to the Best Price provision, a drugmaker is banned from selling to Medicare, the VA, or any other government purchaser. (Medicare and other federal health systems are excluded from the best price guarantee. They can negotiate lower prices than Medicaid rates for the same drugs without forcing manufacturers to offer those super-bargains to Medicaid.)

The burden falls on private payers. But if a Merck or Pfizer offers a PBM, HMO or insurer a discount greater than 23.1%, it’s legally obligated to match that rebate for Medicaid. That requirement has effectively frozen reductions-from-list for the private plans that account for 43% of America’s spending on drugs at the Medicaid floor. Here’s how the math favors Big Pharma, and bilks consumers. For virtually every drug, sales to Medicaid are multiples of revenues from even the biggest health plans. Say a manufacturer offers a drug at full list price would bring $200 million a year from Medicaid. Of course, Medicaid actually pays $155.3 million for the medication thanks to the 23.1% discount. Now imagine that the drugmaker’s largest private customer, a PBM representing a dozen health plans, offers to give the therapy top spot on their clients’ formularies, guaranteeing an 70% increase in sales–all in exchange for a 50% discount. (It’s already discounting 23.1% in line with Medicaid, so its sales to the private plan are $39 million.)

That would be great for the PBM’s customers. They’d get an additional 26.9% reduction in price, and the manufacturer would raise its revenues from the therapy by $12 million or 31%, to $51 million, $30 million from the previous volumes at the lower price, plus an extra $21 million from the 70% increase in units.

It won’t happen. The problem: Right now, that PBM is selling four times more to Medicaid than it’s furnishing to all of its health plans combined. The drugmaker would be forced to hand the same 50% rebate to Medicaid, lowering its sales by $55.3 million to $100 million. That’s more than quadruple the increase in revenues from the private customer. Put simply, because Medicaid is a Big Gorilla, a far bigger force than any private customer, Big Pharma takes a hit by offering PBMs, insurers or HMOs anything exceeding the Medicaid minimum. “The Medicaid best price policy can set a floor under the price,” says Cantrell. “That’s one of the problems with achieving lower drug costs. Blaming the problem on rebates is keeping us from finding market-based solutions.”

What really matters isn’t the size of the rebate, or the list price, but where prices would settle in the absence of such artificial barriers such as Medicaid Best Price. Medicaid’s getting far from a great deal, in part because Big Pharma can artificially set list prices, and keeps raising them so that discounted rates simply rise in lock-step: In the past six years, Medicaid’s total bill for pharmaceuticals has doubled to an estimated $41 billion for 2019.

So would those deals be even better, a lot better, if prices for private plans weren’t dictated by what are essentially federal price controls, and if Medicaid wasn’t barred by Best Price from establishing formularies that could drive discounts well below the Best Price minimum? The answer can’t be provided by what-if models run by Congressional Committees, industry groups or Big Pharma itself. If the Administration is as daring as it thinks it is, it will embrace the treatment that unshackles America’s big buyers, and entrusts the cure to a newly-vibrant marketplace.

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