Stuart R. Gallant, MD, PhD

The United States has a mixed public and private insurance system for health care.  Payments for pharmaceuticals are provided through a complex interconnected payment system.  I thought the topic of payment for pharmaceuticals would make a nice post.

Health Care Payments in the 1960s

Before we get into how the system works now, let’s take a step back not that far—to the 1960s.  There were several changes that occurred in the 1960s (and in the following decades) that led us to where we are now.

Imagine that you are a young person working for a company that offered insurance in the early 1960s.  You go skiing in New Hampshire and have a bad fall which results in your appearing at the hospital in North Conway, New Hampshire.  The doctor sets your leg and sends you home on crutches.  A few weeks later you receive a bill (for an x-ray, casting your leg, some crutches, and some pain medication that the hospital sent you home with) which you mail to your insurance company, and the insurance company pays it.

Some key features of the system:  If you have insurance, you receive insurance through your work (Medicare did not exist yet in the early 1960s), and insurance typically pays the whole thing (hospital stay, procedure, medications, etc.).  At the same time, drugs are relatively cheap, so when you need more pain medication, you pay for it yourself at the local pharmacy.  Finally,the system largely depends on the US mail as requests for payment and payments crisscross in the postal system.

With greater access to physicians following the introduction of Medicare in the mid-1960s, spending on drugs prescribed by physicians increased significantly.  And, the dependence on processing of paper forms created problems within the health care system, particularly as regards drug reimbursements.  Insurance companies were deluged with requests for refunds on relatively small pharmaceutical charges.

Fortunately, a solution to the paperwork dilemma existed.  In 1958, the first widespread American credit card (BankAmericard) came into being.  Using very similar principles, Pharmaceutical Card System (PCS) offered a card that could be used to pay for drugs at certain pharmacies, starting in 1968.  PCS inserted itself as a layer between the patient and the insurer, offering convenience to both sides, for a small fee.

Payments for Pharmaceuticals Today

Fast forward to 2022, the system of payment for pharmaceuticals has become substantially more complex, though on the surface it looks quite similar to the system used in the 1960s:

A patient’s doctor writes a prescription (or types a prescription into a computer), and the prescription is transmitted to a pharmacy.  The patient picks up the prescription and, depending on their insurance status, may pay for a portion of the bill or all of the bill for the drugs.  In addition, the patient may make a payment or co-payment to the doctor for the prescription.  However, before the prescription process can occur, other processes must take place:

• The manufacturer produces the drugs and negotiates a price with a drug wholesaler.  “Chargebacks” may occur when the wholesaler sells the drug for less than the price negotiated with the manufacturer.
• The pharmacy benefits manager (PBM) plays an interesting and central role.  Recall “Pharmaceutical Card System,” the company with the pharmaceutical credit card in the late 1960s.  Since then, numerous PBMs have made a business of understanding and negotiating pharmaceutical prices in the US.  The three leading PBMs in the US are Express Scripts, CVS Health, and OptumRx.  PBMs are paid by insurers to negotiate prices for drugs.  PBMs receive payments both for services rendered and for drug dispensed, and they return a portion of savings on drug purchases to the insurance companies.  As part of agreements with drug manufacturers, the PBMs receive rebates, and they receive also clawbacks from pharmacies.
  • Rebates are incentives from the manufacturer based on sales volume and on placement within the formulary.  The manufacturers want to be placed in a formulary tier which has a lower copayment.
  • Clawbacks occur when the patient pays a higher copayment than the actual cost of the drug.  (The excess payment is returned to the PBM, rather than to the patient.)
• Insurers include both private companies and government agencies (Medicare, Medicaid, VA, DoD, and the 340B program which reduces the cost of drugs supplied to certain types of hospitals).
• Government takes on several oversight roles in pharmaceutical supply:
  • The FDA licenses pharmaceutical manufacturers.
  • National and state legislatures have oversight of doctors and hospital and insurance companies.  And recently, some states have begun to focus on the role of the PBMs.

Incentives

The incentives within this system are complex, and sometimes contradictory:

• Doctors:  Doctors want to heal their patients, but there are limits on what they will do.  Recently, focus has come onto “low value” care—treatments of marginal benefit to the patient.  Most doctors are incentivized to deny treatments to patients in certain scenarios which are defined as “low value.”
• Patients:  Doctors and legislators often focus on barriers to care—high deductible insurance and high copayments.  There is a concern that such barriers result in patients delaying or avoiding necessary medical treatments.  However, copayments are also recognized as a method of controlling overall healthcare spending.
• PBMs:  PBMs have some of the most complex incentives in the system:
  • Copayments, stepped treatment, and tiered formularies:  In addition to copayments, another strategy to manage drug cost is stepped treatment—insisting that a patient fail on a cheaper treatment prior to receiving a more expensive treatment.  This incentive to cost savings has been listed as a barrier to treatment and appears to be particularly irksome to oncologists (because failure of treatment can mean progression of disease).  Underlying both copayments and stepped treatment is the system of tiered formularies in which some drugs are preferred because of lower price.  (Point of Emphasis:  The concepts of tiered formularies and stepped treatment are compatible with good, evidence-based medicine, provided that there is good communication and a flexible understanding that each patient is unique.  The point is not that any of these systems are bad medicine, just that they may be conflicting in some circumstances.)
  • Spread pricing:  One way that PBMs are incentivized is that they may keep a portion of the savings between what the insurance company pays them and what they pay to the pharmacy for dispensed drugs.  The primary issue is one of transparency, and some legislatures are moving in the direction of requiring clearer disclosure of information, like pricing spreads.
• Nondisclosures:  Most contracts in this area include non-disclosures, preventing transparency regarding pricing and markups.

Spending on Drugs

One might reasonably ask how this complex system performs in ways that can be quantified.  Here are some data:

• Use of generics:  According to a 2021 Rand Corporation report [1], “Unbranded generics account for 84 percent of U.S. prescription drug volume—a much larger share than the 35 percent for the OECD comparison countries—but only 12 percent of prescription drug spending at manufacturer prices.”  That’s a very encouraging trend.  Most of the drugs that Americans take to control conditions like high blood pressure, high cholesterol, and diabetes are lower priced generic medications.  These medications constitute the vast bulk of the medications used by primary care physicians.  Some of them appear on the Target $4 and $10 prescription list [2]
• The same Rand report noted, “In contrast, brand-name originator drugs accounted for only 11 percent of U.S. prescription drug volume and 82 percent of U.S. prescription drug spending.”  These are newer medications which have not emerged from patent protection and typically carry a higher price tag.
• Using data from the Centers for Medicare and Medicaid Services on total prescription drug spending in the US versus year, the following plot is generated:

• The year-on-year growth was quite steep in the 1990s and early 2000s; however growth in recent years has slowed.
  • Focusing on the blue line which shows percent increase by year, all the years since 2008 have had less than 3% growth, except for the spike in 2014/2015 when the Affordable Care Act came on-line, and 2019 and 2009 which were only a little bit more than 3%.
  • It’s actually desirable that the spending spiked as a result of the ACA because it demonstrates that new patients were coming into the medical care system as a result of increased coverage.
  • Why is 3% (or approximately 3%) an important number?  In the recent pasts, some states have been targeting approximately 3% for overall health care growth.  (As an example, the Massachusetts Health Care Policy Commission targeted 3.6% over the years 2013 to 2017 and 3.1% over the years 2017 to 2021.)  It appears that some of the incentives against growth in prescription drug spending (for example, tiered formularies, co-pays, stepped therapy) are having the desired effect.
• Rebates:  In the flow chart of pharmaceutical payments provided above, charges flow in multiple directions, but how large are the backflows in the system?  According to a 2016 report [3], the US spent $462 billion on an invoice price basis in 2016, but only $318 billion on a net basis.  In other words, $462 billion was invoiced, and $144 billion flowed backwards as rebates.  So, rebates cannot be thought of as only a small contribution to the system.
• To understand the effect of rebates in a more finely grained way, the AstraZeneca 2021 annual report offers a table for US sales which includes substantial chargebacks, as well as rebates to Medicare and Medicaid and other discounts:

Future Spending on Pharmaceuticals

Some trends to consider:

• As spending on pharmaceuticals continues to attract public attention, it is likely that increased scrutiny will be placed on the individual nodes within this system, particularly PBMs.  This increased scrutiny may include additional requirements for disclosure of accounting data.
• Medicare is an outlier regarding its governmental powers.  Medicaid, VA, DoD, and 340B all have the ability to negotiate pricing, and that power generates significant rebates to these agencies, on the order of 25%.  It will be interesting to see how long Medicare will continue to be the odd bird among these agencies.
• It is worth re-reading the post on financial metrics of pharmaceutical companies (or reading for the first time if you have not taken a look at it) [4].  Pharmaceutical manufacturers are companies with high net margins for a reason.  They require access to large pools of capital to bring drugs to market over long periods of time (sometimes almost a decade).  It was to some extent a happy coincidence that recent growth of pharmaceutical spending has been mostly below 3% per annum.  Buried in that lump sum are novel, highly sophisticated, and complex medicines which require significant price tags in order to treat devastating diseases (cancer, hepatitis C, lysosomal storage diseases).  In many cases, these medications are in effect bringing entirely new patient populations into the medical system because in past generations their diseases would not be treatable.  Eventually, the cost of these drugs will regress to that of generics, but initially appropriate returns need to be generated for investors to ensure the flow of capital for the development of future medications.
• One final thought:  I don’t believe we accurately cost medications.  The true cost of medications should be the amount we spend, less the amount we save by avoiding other treatments (such as hospital stays).  Many medications have the effect of reducing stress on other parts of the medical system (such as hospitals, long-term care facilities, and rehabilitation services), and if we consider those effects, drugs are even cheaper than they already appear on paper.

[1] Mulcahy, A.W., et al.  “International Prescription Drug Price Comparisons,” Rand Corporation (2021).

[2] Target $4 and $10 Generic Medication List.  tgtfiles.target.com/pharmacy/WCMP02-032536_RxGenericsList_NM7.pdf

[3] Quintiles IMS Institute, “Outlook for Global Medicines through 2021” (2016).

[4] pharmatopo.com/index.php/2022/03/06/financial-metrics-of-pharmaceutical-companies-1-of-2/

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