Drug pricing in the US is not a straightforward process. For the most part, this is done by design. Politicians and media have put the blame on “evil big pharma” who charge absurd prices. The reality, however, is that drug pricing is excessively high due to the complexity of the chain. Pharma manufacturers are only a fragment of this chain, the majority of participants are middlemen who add lots of cost and little value. This note will explain how drug pricing in the US works, and how it came to be this unnecessarily complex process for the benefit of all parties involved, except for patients.
The Drug Pricing Process
- Pharma companies develop the drug and set a price (called “List price”)
- Wholesalers transport drugs and sell to pharmacies
- Patient pays copay and pharmacy sends a claim that is paid by insurance company
Seems simple enough. But this process is missing a link that manages the transaction, which adds a lot of complexity.
Meet the Pharma Benefit Managers (PBM). These are middlemen that work for pharmacies, insurance companies, big employers and government programs like Medicare. Their job is to negotiate price of drugs with pharma companies for discounts (“rebates”) to bring the cost of drugs down. As a result of receiving these discounts, PBM pocket part of rebate portion and pass rest of rebate to insurance or employers.
The logical question then becomes: why do pharma companies offer these rebates to PBMs?
That’s because PBMs run drug formularies, a list that controls which drugs are covered under which health care plan or insurance plan. So, if pharma companies want their drug to be covered by insurance, they need to deal with PBMs. The higher the rebate that pharma companies give, the higher the PBM places the drug on the formulary tier, which means more insurance coverage and less patient copay. Obviously, patients want to minimize the copay, so they want drugs that are high on formulary list. To be high on the formulary list, pharma companies need to offer PBMs greater rebates. You see the cycle?
Everyone in the chain makes more money if the drug list price is higher. So, if PBMs want to boost sales, they ask for a higher rebate. In response, pharma companies increase the list price of drugs so that their own sales/margins are not impacted. It becomes a vicious cycle of constant list price increase, which results in higher insurance premiums (more revenues for insurance companies). Patients end up paying the higher insurance premiums, or a higher list price, if uninsured. Lose-lose.
Bottom Line: Drug manufacturers have to play the rebate shell game if they want their drugs to have widespread coverage. So, they raise drug list prices, PBMs "negotiate" a bigger discount and the cycle continues. Patients get screwed the most, since many costs are tied to rising list prices. The truth is that much of the US healthcare system is designed with the interests of drug makers, wholesalers, PBMs and insurance companies in mind...not patients.
A good video explanation of the drug pricing process can be found HERE.
The Oligopoly Behind Drug Pricing Has No Incentive to Change Current System
The biggest PBMs are now owned by “Big Insurance”. Through mergers and acquisitions in recent years, three of the seven for-profit insurers – Cigna, CVS/Aetna, and UnitedHealth – now control 80% of the U.S. pharmacy benefits market. Units of those companies process about 80% of prescription claims and >50% of the US population.
You can clearly see why insurance companies, PBMs and distributors, including pharmacies fall under the same corporate roof and lead to higher revenues and profits with higher drug prices. In fact, big insurers are now getting far more of their revenues from the pharmaceutical supply chain and from taxpayers as they have moved aggressively into government programs like Medicare through PBM negotiations. Whereas before they were generating more revenues from health plans.
A few fun facts that further prove just how valuable these PBMs are for insurance companies:
- CVS generates more revenue from its PBM than from either Aetna’s health plans or its nearly 10,000 retail stores.
- Insurance company Cigna gets far more revenue from its PBM than from its health plans
- UnitedHealth generates approximately a quarter of its consolidated revenues from its Optum PBM division.
- UnitedHealth & CVS are in the top 10 of the Fortune 500 companies
BOTTOM LINE: There is little interest in scrutinizing business practices of big insurance/PBMs for their influence over the drug pricing chain. Policymakers, regulators, and the media would rather scapegoat pharma companies, even though they are minority players in the chain. Until federal law changes, the existing healthcare system in the US will continue to benefit insurance companies and their respective PBMs.
Challengers Taking on the Oligopoly
Earlier in the year, the Biden administration unveiled the first 10 drugs that are going to be subject to price “negotiations” between manufacturers and Medicare, according to the Inflation Reduction Act that aims to make costly medications more affordable (read more here). This is a step in the right direction, but not enough to make a dent. More important are the emergence of Amazon’s Pharmacy business and Mark Cuban’s Cost Plus.
Both businesses aim to cut out the middlemen and, for the most part, negotiate directly with drug manufacturers or a few friendly less egregious middlemen to get lower prices... at least on generics to start. It's not as simple as that, of course... but Cost Plus has come out of nowhere to become a force in mail order pharmacies by charging 15% over what it pays the manufacturer.
And the businesses are making traction. In August 2023, the insurance company California Blue Shield tapped Cost Plus and Amazon to replace CVS Health's (CVS) Caremark as its preferred drug providers.
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