Market Reforms To Improve Pharmaceutical Outcomes

DATE: August 1, 2017

Published by Forbes

The drama of “repeal and replace” resembled an unfunny version of a Monty Python skit, continuously claiming that it was “not dead yet”, and even that it was “getting better” only to be put out of its misery in the end.

The end of repeal and replace will not end the push for health care reform. There are simply too many problems that must be addressed – one way or another. One of these issues gaining traction is the growing push to impose price controls on pharmaceuticals.

Supporters of pharmaceutical price controls have reversed cause and effect – pharmaceuticals are not driving the health care affordability problem; pharmaceutical prices reflect the problem of health care affordability that plagues the entire health care sector. Therefore, pharmaceutical price controls will not solve the growing affordability problem; instead, if they are implemented, the problem will simply manifest itself elsewhere.

While price controls are not the answer, reforms of the pharmaceutical pricing system are still desperately needed. Currently, pharmaceuticals are sold through a complex chain where consumers’ interests are not driving the market and the complicated chain of rebates and bureaucratic rules obscures the information prices are supposed to provide.

Correcting these problems is the best way to improve health outcomes for patients.

In most markets, retailers set the retail price based on the price they paid for the product from wholesalers, plus a competitive price mark-up. Wholesalers set their prices similarly, but based on the price they paid for the product from the manufacturer. Through this sales chain, there is a direct link between the manufacturers’ price and the retailers’ price. Further, both prices reflect the cost of making and delivering the product, and its value to consumers.

The pharmaceutical market does not work this way. The price manufacturers set (the list price) is not the transactions price paid on behalf of consumers. The transactions price reflects the rebates that the middlemen (known as Pharmacy Benefit Managers, or PBMs) negotiate, which are paid by the manufacturers and pharmacies. Since many of the discounts are paid after the medicine has been sold, the actual price of the medicine is unknown when a patient receives her medicine from a pharmacy.

Further, while manufacturer rebates are common in other markets, the rebates will be given to the consumer. This is not the case in the pharmaceutical market. Here, a large percentage of the rebates are often lost to the PBMs. As a result, PBMs are incented to encourage high list prices for medicines, negotiate large rebates for insurance companies, and then pocket a large share of the spread for themselves.

Further, through their control of the formularies (the lists that determine whether an insurance company will pay for a medicine), PBMs have been able to encourage ever widening spreads between the list prices and transaction prices over the last several years. In fact, those manufacturers who do not have high list prices, along with large rebates to PBMs, will not be placed in a top tier of the formulary – threatening their sales volumes. As for insurance companies, the current rebating system also incentivizes them to favor medicines with high list prices but high rebates, over medicines with lower list prices but lower rebates, even if the medicines have similar efficacy and safety.

Due to these adverse incentives, the share of the industry revenues going to the middlemen have greatly expanded as of late – rebates and discounts now account for nearly one-third of all patented drug revenues. Clearly, the rebate and discount system for pharmaceuticals needs to be reformed such that the incentive to create a large wedge between the list price and the transaction price are removed.

There are many other problems with the pharmaceutical market that compound this rebate problem. For example, besides the biosimilars market, in what other market can a manufacturer sell her product for less than her competitors, but earn revenues based on the average sales price charged by the other firms? As another example, when doctors administer intravenous drugs, they are reimbursed based on the value of the medicine. This makes no sense, and creates an incentive to use higher-priced medicines. Obviously, doctors’ reimbursements should be based on the value they add through their expertise, not based on the cost of the medicine administered.

These problems exemplify that the pharmaceutical market is plagued by a web of regulations and restrictions that incent an overly complex pricing environment to the detriment of quality and costs. Reforms should target these disincentives with the goal of improving the market’s efficiency.

Wayne Winegarden, Ph.D. is a Sr. Fellow in Business and Economics at the Pacific Research Institute and Managing Editor for EconoSTATS

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