In the ongoing debate over drug prices, the pharmaceutical industry has been highly effective in shifting the blame to the middlemen — in particular to pharmacy benefit managers. As they currently operate, pharmacy benefit managers are part of the problem. But if incentives were realigned, pharmacy benefit managers could — and should — play more of a vital role in controlling runaway prices for prescription drugs.

PBMs started with the idea that their buying power would reduce health care costs and pass the savings on to consumers. They act like giant buying networks for drugs, representing consumers from multiple employers and insurers. In economic terms, they aggregate demand, which gives them leverage in the market.

PBMs use their buying power, combined with utilization management strategies, to lower the total cost of pharmaceuticals. They have been largely successful: Almost all payers have, at least until recently, chosen to contract with pharmacy benefit managers rather than manage drug procurement internally. PBMs are used by commercial insurers, in Medicare for its Part D benefit, and in the Medicaid program — particularly by Medicaid managed care organizations.


Moreover, in a market with competitive alternatives — such as generics and multiple name brands — pharmacy benefit managers should be able to move patients from more expensive brand drugs to less expensive versions and extract lower prices by playing brands off one another. Net prices are often lower than list prices, but because of the rules of engagement around pharmacy benefit managers and manufacturers, the true cost to the PBM is often opaque. And that’s where things start to go wrong with the PBM model.

These companies are supposed to use their formulary power, management tools, and price concessions to benefit the insurers they serve which, in turn, are supposed to pass the savings on to their customers through more generous benefits and lower premiums. In general terms, pharmacy benefit managers have three revenue sources: fees from the supply chain, rebates from manufacturers, and pharmacy “spreads” — the difference between what they pay for drugs from a pharmacy and what they get paid by the insurer.

This model has generated significant criticism lately for good reason. Commercial insurers complain that pharmacy benefit managers are not passing through the rebate revenue they should. In Medicare, the Medicare Payment Advisory Commission has consistently raised concerns that pharmacy benefit managers are not choosing the lowest-cost drugs. And recent work by 46brooklyn suggests that pharmacy benefit managers are charging Medicaid managed care organizations, or MCOs, much more for generic drugs than they are paying pharmacies.

So where did pharmacy benefit managers go wrong? In three areas: consolidation, rebate revenue, and transparency.

Like everything in else in health care, pharmacy benefit managers have consolidated. There are now three large PBMs — CVS, Express Scripts, and UnitedHealth’s Optum — that account for more than 70 percent of claims volume. Concentrated market share should allow pharmacy benefit managers to extract deeper concessions from manufacturers and the rest of the supply chain. But market power has made a flawed business model sticky, with payers finding few alternatives to the shared rebates.

A second problem involves rebates. Many industries offer incentives of shared savings to align the interests of an intermediary and a buyer. And because payers do not know in advance which drugs and in what volumes they will need when signing a multiyear contract, a fixed-price contract is not realistic. However, rebates are now distorting incentives.

Instead of placing the lowest-priced drug on the formulary and passing the savings to insurers, pharmacy benefit managers may simply supply the drug with the highest rebate. Pharma argues that rebates increase list prices. They also fail to lower premiums if they are not passed on to insurers. But rebates aren’t the only cause of rising drug prices. For example, prices are high and increasing for drugs that don’t offer rebates and in markets without rebates, such as Medicare Part B.

Which brings us to transparency. The drug pricing world is shrouded in secrecy. Some economists argue that price discrimination — when no one knows what anyone else is paying — results in bigger discounts. This is similar to airline ticket pricing. Most travelers buy tickets without knowing what anyone else is paying for other seats on the same flight. Pharmacy benefit managers may be able to get deeper discounts from drug manufacturers if the drug companies can keep the size of the discounts secret and not have to offer them to every other PBM.

Yet economists argue that transparency is one of the characteristics of a well-functioning market. Most government contracting requires full transparency. Greater transparency in drug pricing could encourage competition and force manufacturers to cut prices to gain market share, especially for drugs that compete within a class.

The problem of secretive pricing is further complicated because the whole system of out-of-pocket expense is based on list prices. After all, it is difficult to build a copay model based on net prices if those prices are not transparent. Basing consumer expense on an artificial price to maintain the negotiating leverage of pharmacy benefit managers forces patients to overpay.

The flaws in the system have reached a breaking point. Anthem accused Express Scripts of failing to pass on rebates and sued for $15 billion. Ohio recently terminated its pharmacy benefit managers contracts for issues around spread pricing. Meanwhile, others are attempting to internalize the PBM-insurer conflict by reintegrating. Cigna is trying to buy Express Scripts and CVS Health is buying Aetna.

Pharmacy benefit managers could provide significant value, but the business model must become more closely aligned with the interests of patients and payers. Pharma would love nothing more than to see the PBM model implode, creating the opportunity to extract higher prices by negotiating against smaller, less sophisticated buyers.

Some have proposed that all rebates should be eliminated and pharmacy benefit managers should simply charge fees. But how would payers evaluate the effectiveness of the PBMs? The shared rebate system was designed to align incentives around discounts. A new fee model that better aligns the interests of consumers, insurers, and pharmacy benefit managers must be developed.

Perhaps foundations should support the formation of a nonprofit PBM governed by its customers, similar to the nonprofit generic drug company being launched. The Laura and John Arnold Foundation has supported the development of value-based pricing through the Institute for Clinical and Economic Review, which can be used by pharmacy benefit managers to select drugs that maximize patient value rather than the size of the rebate. CVS recently announced it would use ICER pricing in establishing its formulary.

It is easy to cast pharmacy benefit managers as the bad guys of drug pricing, but with changes to the basic business model, they may be consumers’ best hope for holding down the price of pharmaceuticals.

John Arnold co-founded, with his wife, Laura, the Laura and John Arnold Foundation in 2010.

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  • Great piece on why we shouldn’t move too quickly to dismantle PBMs that on some levels do contain drug costs, albeit way too imperfectly for the reasons presented by John Arnold. But there’s one more thing worth noting about PBM revenues.

    Mr. Arnold writes that PBMs (CVS Caremark, Optum Rx, and Express Scripts) derive revenues from three primary sources: fees from the supply chain, rebates from manufacturers, and pharmacy “spreads.” Those companies also operate huge mail-order pharmacies accounting for three of the largest four national pharmacies in the countries. Walgreens being the other one. See Drug Channels:

    So, as we analyze, and appropriately scrutinize (and criticize), PBMs, let’s remember that they also benefit from the drug price crisis in America through their own pharmacy sales (not just spreads, fees, rebates).

    Additionally, PBMs have used their market power to steer enrollees to their own pharmacies, a great frustration for neighborhood pharmacies, especially mom and pops, throughout the country.

    Where Mr. Arnold couldn’t be more right is the need to maintain pressure on pharmaceutical companies, and not allow them to blame others for the crisis of high drug prices.

    Gabriel Levitt, Prescription Justice

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