At the Intersection of Health, Health Care and Policy
`
`Cite this article as:
`Richard G. Frank
`Prescription Drug Prices: Why Do Some Pay More Than
`Others Do?
`, 20, no.2 (2001):115-128
`Health Affairs
`
`doi: 10.1377/hlthaff.20.2.115
`
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`D r u g C o s t G r o w t h
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`120
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`DRUG
`PRICES
`
`payments for prescription drugs in the United States; in 1999 they
`accounted for an estimated 69.8 percent.9 These figures reflect an
`expansion not only in the share of the population with insurance
`coverage for prescription drugs but also in the level of coverage.
`Over the past fifteen years insured persons have poured into man-
`aged care plans. In 1985 approximately 25 percent of the insured
`population was enrolled in a managed care plan; today that share
`exceeds 75 percent.10 The corresponding figure for the population
`under age sixty-five was 91 percent in 1998. Prescription drug
`spending has grown at rates in excess of 15 percent in recent years.
`This has meant that the impulse to control drug costs has been even
`more pronounced and has resulted in the application of managed
`care techniques to prescription drugs even when they have been
`associated with a fee-for-service (FFS) indemnity health plan (via
`prescription drug carve-out programs). Pharmacy benefit managers
`(PBMs), private firms that specialize in insuring and managing pre-
`scription drug use and spending, have become increasingly impor-
`tant forces. They contract directly with employers or enter into
`subcontracts with health plans. Some HMOs own their own PBM
`companies. It has been estimated that in 1999, 70 percent of private
`health plan prescriptions were managed by a PBM.11
`PBMs and health plans that administer their own drug benefit
`use formularies to steer prescribing toward cost-effective products.
`Formularies (lists of drugs that identify preferred drugs for treat-
`ment of specific illnesses) often contain summaries of scientific in-
`formation about specific drugs that inform clinicians about their
`use. About three-fourths of employers report contracting with
`health plans and PBMs that use formularies.12 Formularies are typi-
`cally tied to a set of administrative processes and financial incen-
`tives aimed at encouraging adherence to the formulary by clinicians.
`Formularies have long been part of the management of care in hospi-
`tals but are relatively new features of health insurance.
`The most direct method for encouraging use of formulary drugs is
`to “close” the formulary, which means that use of drugs not listed
`will not be covered unless prior approval is obtained from the health
`plan or PBM. It is estimated that about 10 percent of all health plans
`and 27 percent of HMOs use closed formularies.13 However, payers
`are often reluctant to use closed formularies, and, as a result, a
`number of other mechanisms are used to steer patients toward for-
`mulary drugs. Copayments are increasingly being used to encourage
`adherence to a formulary. One popular approach is to create three
`tiers of copayments. In the first tier generic drugs carry a copayment
`of say, $5. A second tier might consist of “on-formulary” brand-name
`drugs with a copayment of $15. The third tier is for “off-formulary”
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`DRUG PRICES
`
`
`“Price differentials represent unequal bargaining power across
`different classes ofpurchasers.”
`
`drugs with a $30 copayment
`Therapeutic substitution programs involve utilization review
`and physician contacts to increase and maintain use of formulary
`products. About half of health plans use such methods." Physician
`education programs (sometimes known as academic detailing) rep
`resent another method of encouraging use of formulary drugs. Pi»
`nally, designing physician payment systems that have physicians
`bear some risk for prescription drug costs serves to encourage use of
`lower—price, on— forrnulary products.
`I Market segments and price response. As noted above, con»
`gressional investigators long ago recognized the role of institutional
`structure, buying power, and market forces in explaining the price
`structure for prescription drugs. Formularies enhance a buyer’s bar-
`gaining power, enabling a purchaser such as a health plan or PBM to
`be more aggressive in negotiating prices with manufacturers. By
`being able to redirect the flow of drug sales within a therapeutic L
`category such as proton pump inhibitors or selective serotonin re»
`:::‘f:H°sI
`121
`uptake inhibitor (SSRI) antidepressants, a buyer presents a seller-
`in this case, drug manufacturers—with more price» elastic demand
`In drug classes with multiple products that are therapeutically
`equivalent for most patients, a buyer can use the threat of redirect-
`ing sales to a competing product to stimulate price competition.
`Manufacturers wish to have their products be a preferred drug
`listed on the formulary. As a result, buyers can negotiate a lower
`price. The implication is that buyers that can present profit—maxi—
`mizing manufacturers with the greatest price—sensitivity in sales
`through strong management and high adherence to their formulary
`will realize the largest price concessions. Thus, the price conces—
`sions are responses by profivmaximizing manufacturers to de-
`mands by price~sensitive buyers. Hence, price differentials are not
`related to recouping losses by shifting costs. Rather, they represent
`unequal bargaining power across different classes of purchasers re—
`flected by their ability to shift purchases in response to price.
`The recent implementation of a national formulary by the VA
`illusuates the buying power of formularies. Under the national for»
`mulary, several drug classes were closed. In each closed class, only a
`subset of available drugs were considered to be eligible for reim-
`bursement without resorting to an exceptions process. Using off»
`formulary drugs obtained at a higher price would exert extra pres»
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`D r u g C o s t G r o w t h
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`122
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`DRUG
`PRICES
`
`sure on fixed VA health care budgets at the national and local levels.
`As a result of closing those classes, the VA could convincingly “move
`market share” from one manufacturer’s product to another. The
`ability to redirect sales in exchange for lower prices led to price
`concessions of 16–41 percent below the federal price that already
`was among the lowest in the nation.15
`All of this implies that buyers that can make a credible threat to
`drug manufacturers that they will shift their purchases to another
`drug in a therapeutic class will be able to command the largest price
`concessions. Organizations such as HMOs and mail-order pharma-
`cies that can exert managerial control and create financial incentives
`to affect prescribing decisions are most likely to realize price con-
`cessions. In contrast, individuals buying drugs through a retail phar-
`macy that must deal with hundreds of physicians and dozens of
`health plans cannot steer prescriptions to specific brand-name
`products enough to create meaningful bargaining power. Cash pay-
`ers buying through retail drug stores therefore cannot claim large
`price reductions. For this reason, cash payers buying retail face the
`highest prices for brand-name prescription drugs.
`This point has recently been made clearly in connection with
`national antitrust litigation concerning the pricing of brand-name
`prescription drugs. Judge Richard Posner stated that
`
`the least elastic demanders are pharmacies because they must stock a full range of
`drugs to be able to fill prescriptions. They can therefore be expected to be charged the
`highest prices. In contrast, a hospital, nursing home, or HMO or other managed care
`enterprise has a more elastic demand because it can influence…the physician’s choice
`of which brand…to prescribe. A slight increase in the price of one brand to such a
`purchaser might cause the manufacturer’s sales to plummet. That manufacturers of
`brand name prescription drugs grant discounts to the enterprises we have listed but
`refuse discounts to pharmacies is thus consistent with unilateral profit maximizing
`behavior by the manufacturers.16
`Arbitrage And The Delivery Of Price Concessions
`A variety of institutions in prescription drug markets affect the
`possibility for different buyers to engage in arbitrage. These include
`federal statutes governing the resale of prescription drugs, the
`mechanisms by which prices are implemented, and the nature of
`contractual relations that have evolved in the industry. Here I de-
`scribe the main factors affecting arbitrage in the market for brand-
`name prescription drugs.
`All purchasers of prescription drugs that enjoy discounted prices
`(such as HMOs and hospitals) have an incentive to resell those
`drugs to buyers facing higher price offers (independent and chain
`drug stores). Yet very little reselling occurs, and, as a consequence,
`differential pricing is a stable feature of the market. One important
`constraint on many purchasers’ ability to engage in arbitrage is a
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