The cost of misaligned incentives in the pharmaceutical supply chain

Abstract

Recent concerns over rising drug prices have focused on the role of pharmacy benefit managers or PBMs. While multiple players make up the pharmaceutical supply chain, PBMs are the conductors who effectively decide which drugs are covered and at what cost. Most PBM contracts tie their compensation to a percentage of a drug's list price, creating a financial incentive to favor high-cost, high-rebate drugs on plan formularies at the expense of lower-cost generics and biosimilars. Furthermore, the PBM industry is highly concentrated and vertically integrated with the country's largest health insurers, making it even harder to assess PBM performance and profitability. A simple analysis of annual drug spending at different reporting levels provides important insight into where the money goes and where savings could be achieved. We find that simply delinking compensation to the list price of a drug throughout the supply chain could reduce annual drug spending by more than $95b or nearly 15% of net spending without adversely affecting manufacturers' incentive to innovate.

Key Points.

• Intermediaries in the pharmaceutical supply chain (wholesalers, pharmacies, pharmacy benefit managers [PBMs], and health plans) capture about one-third of total net spending.

• Delinking compensation to the list price of a drug removes the incentive to favor high-cost, high-rebate drugs and could lower drug spending by about 15%.

• In the absence of legislation, there is some evidence of market demand for more transparent PBMs that are unaffiliated with health insurers.

Introduction

Recent concerns over rising drug prices rightfully focus on the role of pharmacy benefit managers (PBMs). While multiple players make up the pharmaceutical supply chain, PBMs are the conductors who effectively decide which drugs are covered and at what cost. They negotiate rebates or price discounts from drug manufacturers on behalf of millions of members, providing an essential counterweight to manufacturers. Rebate agreements can deliver value to plans and patients, but they also put the PBMs at the center of misaligned incentives in the supply chain that ultimately increase patients' costs. Two recent reports by the Federal Trade Commission (FTC)¹ highlighted a range of PBM strategies that raised the cost of prescription drugs to plan sponsors and plan members, such as excluding lower (net) price medications in exchange for alternatives with higher rebates and steering patients to their affiliated pharmacies and away from independent pharmacies. The agency also noted that a lack of competition and price transparency throughout the supply chain can stifle competition from lower-cost drugs. More specifically, contracts tying compensation to a percentage of a drug's list price incentivize high-cost, high-rebate drugs on plan formularies at the expense of lower-cost generics and biosimilars. Recent analyses comparing changes in list and net prices found that from 2012 to 2017, annual inflation of list prices was 12%, while that of net prices was 3%, implying that financial returns to manufacturers have not grown proportionally to list prices.²

Understanding the level and growth of list vs net prices is important for several reasons. First, pharmaceutical manufacturers receive net prices, and thus, their incentives to innovate are based on profits from these prices. Second, a divergence between list and net prices can reduce risk protection for patients because out-of-pocket costs, such as deductibles and coinsurance, are increasingly tied to list prices in order to preserve the confidentiality of net prices. Finally, rebates are of interest in their own right for they reflect the relative market power and business models of intermediaries such as PBMs, which may be changing over time.

Prescription drug spending

We analyze annual drug spending in the United States from 2018 to 2023 at different levels based on IQVIA's Longitudinal Access and Adjudicated Data (LAAD) Sample Claims Data and CMS National Health Expenditures. A simple examination of these data can provide important insight into where the money goes and where savings could be achieved.³

The top, light-blue line in Figure 1 is staggering but largely immaterial. Based on list prices, the total drug spending in the United States was $917b in 2023. Fortunately, very few purchasers pay list price, and thus, the darker blue line is the more relevant measure, showing the total amount of drug spending in 2023 after all discounts ($650b). The difference between the 2 (blue) lines reflects an average discount of 29% off list prices. Annual growth rates in spending (P*Q) to the right of the chart show that despite growing public angst over the affordability of medications, growth in net drug spending was modest (5.2% per year) given that the number of prescriptions filled per year (Q) rose steadily (data not shown) and that aggregate patient out-of-pocket costs increased at a lower rate than overall inflation during this period.

Figure 1.

Medicine spending at selected reporting levels, US$Bn. Source: IQVIA LAAD Sample Claims Data, Dec 2023; IQVIA Institute, Mar 2024; CMS National Health Expenditures, Dec 2023.

The third (green) line in Figure 1 shows how much of the $650b in annual drug spending is retained by manufacturers. Drug manufacturers had revenues of $435b in 2023 or roughly two-thirds of the total net spending. Subtracting $435b in manufacturer revenue from the total net spending indicates that intermediaries (wholesalers, pharmacies, PBMs, and health plans) captured $215b or about one-third of the total net.

We do not know precisely how the $215b is distributed across wholesalers, pharmacies, and PBMs (treating PBMs and health plans as a single entity given their common ownership), but we can apply some simple estimates of fair compensation to estimate potential savings from delinking their compensation from the list price of a drug.

Wholesalers and pharmacies

Wholesalers purchase drugs from manufacturers in bulk, typically adding a markup to the list price (average of about 3%) before selling and distributing to pharmacies, hospitals, and long-term care facilities. Wholesalers compete with each other for contracts with providers and pharmacies; however, their incentive to lower total supply chain costs is mitigated because their revenue is tied to list prices. Furthermore, the market is highly concentrated, with the “Big-3” wholesalers—AmerisourceBergen, Cardinal Health, and McKesson Corporation—accounting for more than 90% of wholesale drug distribution in the United States.⁴ Compensating wholesalers with a fixed fee per prescription drug unit or service would increase transparency and efficiency. Another option would be to base wholesaler compensation on a drug's net price. While this would require postsale adjudication, applying a 3% markup to net rather than list prices would reduce gross revenues to wholesalers from $27.5b to $19.5b, a savings of $8b in 2023.

The stability of retail pharmacies is important given the role they play in community health, particularly in rural areas. While there is an oversupply of pharmacies in large urban areas in the United States, intense competition and declining reimbursements from PBMs have contributed to shrinking profit margins and a large number of pharmacy closures over the past 5 years, particularly independent pharmacies.⁵ Generic prescriptions account for more than 90% of the dispensing activity but generate a small fraction of prescription revenues. By contrast, higher margin specialty drugs account for over 40% of the pharmacy industry's prescription revenues, but due to PBM contracts, are predominantly filled at PBM-owned mail pharmacies.⁶

Delinking pharmacy revenue from the price of a drug makes complete sense given that a pharmacy's overhead expenses (rent, labor, stock) are largely fixed irrespective of the drug dispensed. Professional organizations estimate the average cost of dispensing a drug is $10 to $12 per prescription and $10.50 is a common dispensing fee in many states' fee-for-service Medicaid programs.^7,8 Both estimates are in line with Mark Cuban's Cost Plus Pharmacy (MCCPP), a model for cost-plus pricing. MCCPP's price includes a 15% markup over acquisition cost, plus a $5 dispensing fee and $5 for shipping. Multiplying 6.9b outpatient prescriptions³ in 2023 (retail and mail) by $10.50 yields gross pharmacy revenues of $72.5b.

PBMs

Similarly, tying PBM compensation to the list price of a drug misaligns incentives to favor lower priced products. Undisclosed discounts, hidden fees, and postsale clawbacks are some other PBM strategies that would be largely eliminated if PBM contracts were based on 2 simple metrics, quality and cost, where cost would be a flat administrative fee per member per month or per prescription. Suppose a fair payment for core PBM services is $4 per claim with potential bonuses of up to 25% (to $5 per claim) for high quality administration such as being in the top quartile of patient satisfaction and below average spending growth. A fixed administrative fee of $4 per claim would result in aggregate PBM net revenues of $27.6b in 2023 (excluding bonus payments). This excludes manufacturer payments to PBMs for ancillary services such as data analytics, disease management, or other consultative services, which may be valuable but should be disclosed to the plan sponsor to avoid simply renaming rebates and other price concessions.

In total, delinking compensation from list prices for wholesalers, pharmacies, and PBMs could reduce drug spending by $95.4b or nearly 15% of net spending without adversely affecting manufacturers' incentive to innovate (see Table S1 for details).

Discussion

A lack of transparency and inability of plan sponsors to assess how much PBMs generate in savings and how much they retain for themselves is the root issue, with plan sponsors and others having little to no ability to monitor PBM behavior. A cursory analysis of aggregate drug spending highlights the financial cost of these misaligned incentives throughout the supply chain.

Current legislative proposals at the federal and state levels include a range of measures intended to increase transparency of PBM business practices. While there appears to be bipartisan support for such reforms, the industry will not go quietly. CVS Caremark President David Joyner defended the role of PBMs in a testimony before Congress in July 2024, blaming drug manufacturers for high list prices. Meanwhile, Express Scripts sued the FTC calling for a withdrawal of their 2 reports. This is not the first time PBM practices have come under scrutiny, yet they have successfully adapted their revenue streams in response to criticisms, for example, over opaque pricing and rebate sharing. Decreases in retained rebates were offset by growth in profit on prescriptions filled through affiliated mail order and specialty pharmacies, as well as administrative service fees collected from pharmaceutical manufacturers for, among other things, administering, invoicing, allocating, and collecting manufacturer rebates. Under these arrangements, higher list prices translate into higher profits for the PBM—effectively recreating the rebate retention model that they were supposed to replace. This suggests that modest reforms aimed at increasing transparency or limiting further consolidation will not alter incentives or substantially reduce drug prices. However, delinking compensation to the list price of a drug throughout the supply chain could mitigate the perverse incentives in the market and be an easy first step in making medicines more affordable.

Supplementary material

Supplementary material is available at Health Affairs Scholar online.

Funding

None declared.

Conflicts of interest

Please see ICMJE form(s) for author conflicts of interest. These have been provided as supplementary materials.

The author has no relevant financial or nonfinancial interests to disclose.