Pharmacy Benefit Managers: Fixing Healthcare Market Failures Or Straining Regulatory Control?

By Ralf Boscheck, Lundin Family Professor of Economics & Business Policy, IMD Business School

On January 20, 2017, Bloomberg reported the FTC had not been reassured by Walgreens Boots Alliance’s proposed sale of 865 stores to clear its acquisition of Rite Aid Corp.¹ The $9.4 billion tie-up was to make Walgreens the nation’s largest drugstore chain followed by the current market leader, CVS Health, and Fred’s Pharmacy — the latter of which was put forward as the buyer of Walgreens’ spun-off assets. However, more important than its potential effect on pharmacy retailing, critics were troubled by the deal’s likely impact on pharmacy benefit managers (PBMs), which are trusted, but recently doubted, to keep drug prices under control.

Since their inception in the late 1960s, PBMs managed drug lists and prescriptions for insurers and used sizable patient pools to lower reimbursement rates with pharmacies and prices paid to drug suppliers. To ensure competition among independent PBMs would continue to deliver shared savings, in the late 1990s the FTC acted quickly to avert conflicts of interest inherent in early combinations of PBMs and drug producers.² A decade later, however, the direction of takeovers shifted and consolidating PBMs began to merge with pharmacists. By the end of 2016, the largest two of such combinations — CVS/caremark and Express Scripts/Medco Health Solutions — accounted for more than one-fifth of the almost $4 billion in U.S. prescriptions dispensed annually.³ Clearly, Walgreens’ acquisition of Rite Aid’s PBMs could help the former face up to CVS. But it would also add to industry consolidation and possibly hamper independent pharmacists’ ability to compete, force drug producers to ramp up drug prices to meet growing rebate demands, or, conversely, pervert the incentives of integrated PBMs to steer patients to more costly drugs rather than cheaper, equally effective ones.

Mirroring these concerns, a public drug-price blame game surrounded the FTC review and saw independent pharmacists and drug producers zeroing in on PBMs as the main culprits. At the same time, the FTC itself was called upon to reconsider its allegedly laissez-faire position on healthcare markets,⁴ if only to avoid that a growing number of U.S. states were to enact new regulations and licensing rules to curtail presumably abusive PBM behavior.⁵ Observing the situation, Moody’s warned that if any of the legislative proposals aimed at reining in PBMs took hold, the value of the PBM model would be lost.⁶ Given the contradictory atmosphere, how is one to know whether structural relief is needed or, on the contrary, if overregulation should be averted?

This two-part article addresses some key issues emerging from the current debate. This first part will provide a background on PBMs and the monopolization fears related to them.

PBMs — Market Contexts and Benefits

U.S. healthcare spending, currently projected to grow by 5.8% annually and to represent 20.1% of the total economy by 2025,⁷ has made market reforms a critical and ongoing priority of regulatory policy.⁸ Healthcare markets are intrinsically fragile simply because providers deliver heterogeneous services to generally ill-informed patients who cover only a fraction of the costs. Intermediaries respond to the root causes of failing market coordination by injecting know-how, aggregating demand, and screening supplies. But they themselves are subject to regulatory concerns, as opaque practices could give rise to deceptive conduct and the scale of operations may eliminate actual, or foreclose potential, competition. PBMs are a case in point.

PBMs organize the sale and reimbursement of prescription drugs among producers, pharmacists, and diverse sets of private and public health plans. They leverage their industry know-how and buying power to obtain rebates and discounts from drug manufacturers and pharmacists. Health plans conduct competitive biddings to select PBMs based on the lowest possible drug prices, the most convenient access to pharmacy networks, the quality of data analytics, and the services offered to improve members’ health outcomes.⁹ PBMs in turn create markets. They negotiate a discount off the average wholesale price they will pay to reimburse pharmacists, who again pay drug suppliers a typically lower average manufacturer price. At distribution level, a PBM’s strong bargaining power based on patient numbers and available retail alternatives, including mail-order, negatively affects the margins of pharmacists. At product supply, the uniqueness of a given drug, based on its brand strength, IP protection, or locked-in plan preference, may limit a PBM’s ability to extract discounts from suppliers; lacking any such leverage, manufacturers typically offer rebates to promote their products. Generics are reimbursed based on maximum allowable costs (MACs), with lower MACs paid to pharmacists and higher MACs charged to plan sponsors. PBMs are not required to share information about the extent and sources of these spreads.

At the end of 2016, around 30 PBMs — some independent, some owned by insurers or retailers — were managing pharmacy benefits for over 253 million Americans. By forcing drug producers and pharmacists to compete for access to selective formularies and distribution networks,¹⁰ PBMs were estimated to save plan sponsors almost one-third of the prescription drug expenditure, amounting to nearly $2 trillion between 2012 and 2021.¹¹ Also, facing competition themselves, they delivered these benefits at ever lower rates.¹² PBMs arguably create sizable value. And yet, the opacity of their operations fuels growing concerns about the fair sharing of these gains and the very nature and proper regulation of this type of business.

Monopolization Fears

“We know of no other market in which there has been such a significant number of prominent enforcement actions and investigations, especially in a market with such a significant impact on taxpayers. Simply put, throughout the United States, numerous states are devoting considerable enforcement resources to combating fraudulent and anticompetitive conduct by PBMs. This is because those activities are taking millions of taxpayer dollars and denying government buyers the opportunity to drive the best bargain for the state.”¹³

A recent review of litigations brought against Caremark Pharmacy Services (Caremark), Medco Health Solutions (Medco), and Express Scripts underscores some potential antitrust and legal concerns surrounding the PBM industry. Many of the practices that are intrinsic to the PBM business model may violate an array of principles outlined in the Sherman Act, the Federal Trade Commission Act, the False Claims Act, and the Employment Retirement Income Security Act.¹⁴ They include “restraint of trade through supra-competitive and/or coordinated pricing arrangements; attempts to monopolize” or enforce self-dealing “through the vertical integration of mail-order pharmacies; unfair and deceptive trade practices in the concealment of rebates, the creation of MAC pricing spreads, (…) and kickbacks in the form of drug manufacturer rebates given in exchange for increases in market share.”¹⁵ At this stage, however, any such review amounts to little more than a listing of “allegations and settlements, rather than verdicts or hard determinations.”¹⁶ Evidently, issues are unclear and regulatory responses far from obvious. Case-in-point, the highly publicized apprehension regarding MAC spreads:

Reimbursement based on MACs represents a prospective pricing formula that originated with Medicaid in the late 1980s to limit payments to dispensing pharmacies to a flat amount irrespective of actual drug acquisition costs, the so-called “federal upper limit (FUL).” In wake of this, 45 states developed an even lower fee base linked to pharmacies’ average acquisition costs, the Medicaid MACs.¹⁷ By importing this fixed-price method into the private sector, PBMs were able to side-step complications in building competitive pharmacy networks and to effectively cut spending on prescription drugs for associated plans. Obviously, offering high rates to pharmacists ensures tight distribution networks that may, however, prove unable to compete on costs; fees that are too low limit the network’s attractiveness, as only a few retailers will join or stay. By paying the average acquisition cost of a benchmark pharmacy, PBMs find a middle ground that simplifies transactions, avoid the distortions and wastes of commission-based or cost-plus pricing, and prompt pharmacists to shop around for the cheapest generics.¹⁸ Hence, efficiency is improved and incentives for private and public gain are aligned – at least in the aggregate. Of course, it may be argued that PBMs could use pricing to drive traffic into integrated mail-order channels or that a higher rebate may ultimately succeed in promoting a more expensive drug relative to an equally effective alternative. Also, some may find it difficult to adjust, and others may not consider the gains to be fairly shared. But would any of these concerns justify regulatory intervention? Why would one assume market relief is effectively foreclosed? Or should PBMs be deemed special businesses with a special mission and an implicit special duty?

On the retail side, for one, there seems to be sufficient choice and countervailing power. PBMs do create competition among the 66,000 retail pharmacies nationwide for positions in their networks that give greater prescription volume in return for lower reimbursement rates. But contracts are not exclusive, and pharmacists are typically affiliated with a number of PBMs. Moreover, 80 percent of independent pharmacies participate in one or more of the three leading group purchasing bodies — pharmacy services administrative organizations (PSAOs) — to negotiate with pharmaceutical manufacturers and PBMs.¹⁹ Next, given that Medicare Part D, the TRICARE program, and some private plans require that PBMs assure access to a minimum number of pharmacies in a region, independent pharmacies in rural areas command a premium.²⁰ This is partly why PBMs augmented their mail-order businesses, offering lower prices than retail and non-PBM-owned mail pharmacies. But also here, the FTC concluded PBM-mail-order operations do not create a conflict of interest but rather enhance customer benefits.²¹ Finally, over the last five years, despite an overall stable retail volume and an accelerated integration of independent pharmacists into retail chains, the number of independent pharmacies has actually grown by 15 percent, and their average profit margin has increased to 23 percent of revenues.²²

On the plan-side, a large number of national and regional PBMs offer competing services and products²³ to payers that individually or as a group insist or could insist on increased transparency or stepped-up monitoring. Of course, going forward, choice may be reduced as a continued consolidation of U.S. health plans may require PBMs to “level throughput,” i.e., maximize the benefits of scale across the market.²⁴ To the extent that competition in the market may thus be limited and imposing it would reduce efficiency, existing bidding processes suffice to create competition for the market and make PBM contracts contestable. As cooperations unfold, concerns about the fair sharing of gains may reflect limitations in the underlying incentive-compatible, self-enforcing contracts and could trigger litigation or a less drawn-out process of arbitration. At the end, a plan could terminate the contract, switch to another PBM, or take the operation in-house.²⁵ Put differently, plans also seem to have access to ample market or legal relief. And yet, over the last five years, 38 states have adopted new rules to curb PBM behavior.

In the second part of this article, we’ll look at how these state’s actions affected the fiduciary status of PBMs and at federal and state efforts at enforcement and regulation.

Endnotes:

1. McLauglin, D. et al (2017) Walgreens Faces U.S. Antitrust Concerns over Rite Aid Fix, Bloomberg News, 20.01.2017
2. FTC (1998) Merck settles FTC Charges, at https://www.ftc.gov/news-events/press-releases/1998/08/merck-settles-ftc-charges-its-acquisition-medco-could-cause, last visited 27.01.2017; see also Pitovsky, R. (1995) Subsequent Review: A Slightly Different Approach to Antitrust Enforcement, at https://www.ftc.gov/es/public-statements/1995/08/subsequent-review-slightly-different-approach-antitrust-enforcement, last visited 27.01.2017
3. Full House Committee on Oversight and Government Reform (2016) Developments in the Prescription Drug Market: Oversight, February 4^th 2016, at https://oversight.house.gov/hearing/developments-in-the-prescription-drug-market-oversight, last visited 27.01.2017
4. AAI (2017) Mergers, Market Power, and the Need for More Vigorous Enforcement, Transition Report to the 45th President of the United States, at http://www.antitrustinstitute.org/sites/default/files/mergerfinal.pdf, last visited 27.01.2017
5. Imber, S. et al (2016) Pharmacy Benefit Managers Face New Licensing Requirements, Jdsupra Business Advisors, at http://www.jdsupra.com/legalnews/pharmacy-benefit-managers-face-new-51823/ last visited 27.01.2017
6. Moody’s (2017) US Pharmacy Benefit Managers - PBMs at Risk as Rising Drug Prices Draw Ire, at https://www.moodys.com/research/Moodys-Pharmacy-benefit-managers-face-risk-as-rising-drug-prices--PR_359544?WT.mc_id=AM~WWFob29fRmluYW5jZV9TQl9SYXRpbmcgTmV3c19BbGxfRW5n~20161213PR_359544, last visited 27.01.2017
7. Kehan, S. et al (2016) National Health Expenditure Projections, 2015–25: Economy, Prices, And Aging Expected To Shape Spending And Enrollment, Health Affairs, July 2016, http://content.healthaffairs.org/content/early/2016/07/12/hlthaff.2016.0459, last visited 03.02.2017
8. For earlier discussions see Boscheck, R. (1996) Health Care Reform & the Restructuring of the Pharmaceutical Industry, Long Range Planning, pp. 629-642
9. See Pons, N. (2015) Written Testimony, Statement before Subcommittee on Regulatory Reform, Commercial and Antitrust Law Judiciary Committee, November 17, 2015, at http://docs.house.gov/meetings/JU/JU05/20151117/104193/HHRG-114-JU05-Wstate-PonsN-20151117.pdf, last visited 03.02.2017
10. Arthur, B. (2015) State of Competition in the Pharmacy Benefit Manager and Pharmacy Marketplace, Statement before Subcommittee on Regulatory Reform, Commercial and Antitrust Law Judiciary Committee, United States House of Representatives, November 17, 2015, at http://www.coapharmacy.com/hearing-the-state-of-competition-in-the-pharmacy-benefit-manager-and-pharmacy-marketplaces/, last visited 03.02.2017
11. Visante (2011) Pharmacy Benefit Mangers (PBMs): Generating Savings for Plan Sponsors and Consumers, prepared for PCMA, Sept. 2011; at http://thatswhatpbmsdo.com/wp-content/uploads/2016/02/visante-pbm-savings-study-Feb-2016.pdf, last visited 03.02.2017
12. Federal Trade Commission (2012) Statement Concerning the Proposed Acquisition of Medco Health Solutions by Express Scripts, Inc., FTC File No. 111-0210, April 2, 2012; at https://www.ftc.gov/sites/default/files/documents/public_statements/statement-commission-concerning-proposed-acquisition-medco-health-solutions-express-scripts-inc./120402expressmedcostatement.pdf, last visited 03.02.2017
13. Letter from Mass. State Senator Mark Montigny (D) to FTC Chairman Deborah Platt Majoras (May 11, 2005)
14. The North Jackson Pharmacy's complaint against Express Scripts illustrates these concerns: “As a result of the illegal agreements and/or conspiracies, Defendant has caused the Plaintiffs to suffer financial loss in that Defendant, with its monopolistic market strength: (i) forces independent pharmacies to accept reimbursement rates that are set at unconscionably low levels; (ii) place on its formulary those drugs which affords it the highest ‘spread’ and therefore the greatest profit; (iii) receives kickbacks and rebates from drug manufacturers in exchange for ‘pushing’ its drugs on consumers which is done by placing a manufacturer's drugs on the PBMs' formulary regardless of whether that drug is the cheapest or most effective drug in its particular group; (iv) refuses to give pharmacies access to the market of the retail sale of prescription drugs that are reimbursable by insurance except on terms and reimbursement prices that leave no economic margin for the pharmacies' survival; (v) steers health plan members to mail order pharmacies, which are owned by the PBMs, by prohibiting retail pharmacies from providing more than a 30-day supply of drugs, while allowing the PBMs own mail order pharmacies to provide 90-day supplies; (vi) takes pharmacists and physicians out of the medical care equation by either limiting, or altogether removing, their discretion to determine the fitness of a prescription drug; ... and (viii) unilaterally imposes contract changes on Plaintiffs, including changes in reimbursement rates.” See First Am. Class Action Compl. at 20, N. Jackson Pharm., Inc. v. Express Scripts, Inc., 345 F. Supp. 2d 1279 (N.D. Ala. 2004) (No. 5:03-2696)
15. Meador, M. (2011) Squeezing the Middelman: Ending Underhanded Dealing in the Pharmacy Benefit Management Industry Through Regulation, Annals of Health Law, Vol. 20, Iss.1, pp. 77-108, here p. 98
16. Ibid, p. 98
17. See Office of Inspector General, Medicaid Drug Pricing in State Maximum Allowable Cost Programs (August 29, 2013), at https://oig.hhs.gov/oei/reports/oei-03-11-00640.asp; last visited 03.02.2017
18. According to a 2015 Generic Pharmaceutical Association (GPhA) report, generic utilization has saved U.S. patients and purchasers more than $1 trillion over the last decade and generics now account for more than 86 percent of prescriptions in the U.S. "Generic Drug Savings in the U.S." Generic Pharmaceutical Association, 15 Aug. 2015. http://www.gphaonline.org/media/wysiwyg/PDF/GPhA_Savings_Report_2015.pdf; last visited 03.02.2017
19. GAO. PRESCRIPTION DRUGS: The Number, Role, and Ownership of Pharmacy Services Administrative Organizations. Published: Jan. 29, 2013. Publicly Released: Feb. 28, 2013
20. Code of Federal Regulations, Title 42, § 423.120
21. Federal Trade Commission, “Pharmacy Benefit Managers: Ownership of Mail-Order Pharmacies,” August 2005
22. Fein, A. (2014) "Profits Up Again for Independent Pharmacy Owners." Drug Channels. Pembroke Consulting, Dec. 2014
23. See Statement of the Federal Trade Commission Concerning the Proposed Acquisition of Medco Health Solutions by Express Scripts, Inc. FTC File No. 111-0210, April 2, 2012
24. See FTC (2017) Competition in the Healthcare Market, at https://www.ftc.gov/tips-advice/competition-guidance/industry-guidance/health-care, last visited 08.02.2017
25. See Anthem, Inc. vs. Express Scripts, Inc. United States District Court, Southern District of New York, filed 03/12/16, 16CV2048

About The Author

Ralf Boscheck is the Lundin Family Professor of Economics and Business Policy at IMD business school, where he is program director of IMD’s MBA program. With more than 20 years of teaching in a number of executive programs, Professor Boscheck believes in using intensive and direct interaction to develop technical competencies, self-awareness and moral judgment. You can reach him at ralf.boscheck@imd.org.