Arnold Kling  

Negotiating Drug Prices

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A CBO report says,


A chain pharmacy usually dispenses prescriptions as written by the physician for brand-name drugs under patent protection; so even though a chain pharmacy may buy a large volume of brand-name drugs under patent protection, it generally cannot negotiate prices for them that are low compared with the prices negotiated by purchasers with more choice. In contrast, a health plan can choose to cover only one or two brand-name drugs from a set of drugs that are considered to be therapeutic substitutes; therefore, a health plan can negotiate lower prices from manufacturers (in the form of rebates) by buying a large volume of the brand-name drugs of the plan’s choice.

The point is that you are only in a position to demand a lower price for a drug if you can threaten to buy a different drug instead.

The report itself drew no inferences from this, but there are news stories saying that the CBO just trashed the Democrats proposal. I don't think the Dems want to have Medicare threaten to take grandma's favorite drug off the Medicare list of approved drugs. Put that together with the CBO analysis, and you conclude that without that threat Medicare will have no negotiating power.

If the drug companies buy this analysis, then they should just lay down and let the Dems have their bill. Somehow, I doubt that they'll approach it that way...


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COMMENTS (8 to date)
anon45 writes:

What did the Canadians do to get the low prices they enjoy for drugs in their national plan?

We can buy from Canada and save 25-40% on the 6 drugs our family uses.

Canada has 32-33 million people we have 300+ million.

John Thacker writes:

The Canadians can much more credibly threaten to break patent protection, I suppose. Canada has generic manufacturers, but no research drug companies. Threatening to break patent protection is essentially a free lunch.

That said, I'm still surprised by the interpretations of the CBO report. It seems rather apparent to me that the government as a single buyer could negotiate lower drug prices. It would simply come at the cost of future drug discoveries. The government has negotiating power with drug companies that pharmacies do not.

Carl Marks writes:

The government does in fact have a very credible threat, since they are the ones who control property rights. Congress could easily make the treat to change the duration of patent protection for drugs, or to apply simple price controls. If the pharmas still won't go along, the dems could just remove their patents immediately.

I might finally add that this would probably be supported by a majority of the public, in the same way that minimum wage is.

"Forget what is not seen," says the redneck in Georgia, "my fat wife has to pay $400 a month for medicine. If prices keep moving like this, she'll have to stop taking them and may have to exercise instead."

Don Lloyd writes:

"...
A chain pharmacy usually dispenses prescriptions as written by the physician for brand-name drugs under patent protection; so even though a chain pharmacy may buy a large volume of brand-name drugs under patent protection, it generally cannot negotiate prices for them that are low compared with the prices negotiated by purchasers with more choice. In contrast, a health plan can choose to cover only one or two brand-name drugs from a set of drugs that are considered to be therapeutic substitutes; therefore, a health plan can negotiate lower prices from manufacturers (in the form of rebates) by buying a large volume of the brand-name drugs of the plan’s choice...."

This description cannot be correct or complete as far as prices paid by pharmacies vs health plans go since pharmacies often fulfill health plan prescriptions. The exact same prescription pills bought by a consumer from a pharmacy will yield a $5-$35 co-pay from a consumer insured by a health plan with a drug benefit while another consumer without a drug benefit or even insurance will almost always pay a much higher amount.

I would very much appreciate finding out just how all the moving parts work in the overall provision and distribution of prescription drugs.

Regards, Don

Andrew writes:
I would very much appreciate finding out just how all the moving parts work in the overall provision and distribution of prescription drugs.

This is correct but it isn't the complete story. CVS, Walgreens, RiteAid and all other pharmacies negotiate directly with manufacturers or use a Group Purchasing Organization to negotiate on their behalf (if they are legally able to do so). Whatever price they negotiate is independant of what the insurance company pays. The insurance company decides which drugs to cover and how much to pay. It develops a formulary of covered drugs and a payment rate. Many payment rates are based on either AWP (Average Wholesale Price), AMP (Average Manufacturing Price) or MAC (Maximum Allowable Cost). A sample payment rate might be AWP minus 15% plus $1.50 for brand name and MAC plus $1.00 for generic drugs. (The numbers are made up, but basically this is how it works.) In almost all cases, the insurance company has a clause that says the payment will be the lesser of what the pharmacy actually bills or the agreed upon formula. Most insurance companies use a different calculation for brand name drugs vs. generic. They also might adjust the formula for 90 day quantities, specialty items, or for other reasons. The insurance company also negotiates with drug manufacturers for rebates. The rebates can be massive and are guarded secrets. For all of the part D plans that cover one drug in a class but not others, you can bet that rebates were a major reason for that decision.

When a patient gets a prescription filled, the pharmacy fills the prescription and provides it to the patient. The pharmacy submits the claim thru the NCPDP system (www.ncpdp.org) which tells the pharmacy how much the patient's co-pay should be based upon their insurance plan's terms. The patient pays whatever co-pay is called for by their insurance plan and the remainder is paid based on the set formula agreed to be the pharmacy and the insurance plan. So the actual payment to the pharmacy in my example would be AWP minus 15% + $1.50 minus the patient's co-pay. Whatever is leftover is paid by the insurance plan. The exception is that if the pharmacy's charge for the item works out to less than the formula rate. In this case the insurance company pays the actual charge less the co-pay. What this means is that for insured patients the pharmacy can charge anything they like, they simply won't be paid more than the formula rate. However, if they charge too little, they will receive less from the insurance company. This isn't the case for a patient who pays cash. The patient who pays cash must pay whatever the pharmacy's going rate is for that item. That is why the insured patient pays only a co-pay and the uninsured patient pays a much higher amount. (By the way, this is how many other health services work including doctors, hospitals, and most other providers. And the government prohibits providers from charging anyone less than what they charge Medicare, meaning if you want full payment from Medicare you have to charge the uninsured patient the same amount. This obviously is a different issue, but something many people don't realize.)

This all occurs millions of times per day, everyday. The insurance company has a contractually defined reconciliation process with each manufacturer. Based on the total volume of prescriptions filled and paid for by the insurance company for that manufacturer's drug(s) and possibly other factors like the % of prescriptions of that class of drugs that are that manufacturer's products, a rebate is calculated and paid to the insurance plan.

I think the proposal for the government to negotiate is a very bad idea and could potentially increase everyone's costs. Think about it this way, there are many Statins (to lower cholesterol). Only one major one is generic, Simvistatin (Zocor). The rest, Lipitor, Crestor, and others are still patented, name brand products. There are millions of Part D beneficiaries on Lipitor. If the government tries to negotiate with Pfizer over the price of Lipitor, Pfizer could very well tell the government to get lost. Then the government can either decide to not cover Lipitor and cause millions of seniors to get upset and favor the Republican system, or they can pay whatever Pfizer demands for their drug. If I were Pfizer in this case, I might even consider raising the price, since to the politicians, the cost of not covering a drug like this costs more politically than just paying the asking price. Lipitor is just one example amoungst hundreds of similar items.

Oh, and the VA as well as many foreign governments do not cover all drugs within a class. In fact, in certain cases they might not cover any drugs in a class if they view the best price they can negotiate as more expensive than the disease.

The part D plans are not stupid. They have every incentive in the world to negotiate the best prices they can. By the looks of it, they have negotiated some really very good pricing based on the net cost results, total premiums charged, and future cost estimates. There is an incredible amount of competition between the plans, and any plan that cannot get good pricing will quickly exit the market.

Richard Wilson writes:

The Canadian system institutes price control mechanisms that prevent pharmaceutical ventures from freely pricing their products. While some will quickly utilize this as an opportunity to mention that Canada isn’t a world leader in pharmaceutical and biotech research, do recall that Canada has a population that’s one-tenth of America’s and an economy that’s less than one-tenth America’s, meaning that R&D in Canada would naturally be far less than aggregate R&D in the United States.

Pharmaceutical companies enjoy unprecedented profit margins that come at the expense of consumers. As a sector, the pharmaceutical industry enjoys the status of being the most profitable sector in the entire country. Many people in support of the profit motive will claim that the enormous earnings by the sector are necessary for financing very risky and expensive R&D projects. However, little of the sector’s total revenue is actually invested in R&D. In 1999, for example, Merck invested 6.3% of revenue in R&D, while 18% of revenue came in the form of earnings. In the same year, AMGEN invested 27% of revenue in R&D, while reaping a profit margin of 33% on sales. Abbot invested 9.1% of revenue in R&D, while pocketing 19% of revenue. Many pharmaceutical and biotech enterprises actually squander more money on drug pushing through advertising than they appropriate for scientific research.

While scientists are central to developing innovative medications, they’re under compensated compared to the Corporate Executive Officers that do nothing to contribute to scientific breakthroughs. Regardless of their lack of scientific contribution, pharmaceutical CEOs banked like there’s no tomorrow! For example, in 2000, the CEO of Pfizer deposited $40.1 million into his piggy bank. Merck’s Executive VP strenuously slaved for his $26.5 million. Merck’s President of the Americas looted $19.6 million from the company’s customers.

Even if price controls were introduced that capped drug prices at 90% of their current value, the pharmaceutical sector would still remain America’s most profitable. I really believe the time has come to aggressively negotiate for lower Rx prices. If Medicare were to stop carrying a certain prescription drug, such as a cholesterol lowering medication, it could potentially ruin a company’s performance. I don’t think Pfizer would ever consider telling Medicare to “screw off.” If Medicare and Medicaid were consolidated into a single negotiating authority, any company that told the public health system to “screw off” would be basically bankrupted.

Don Lloyd writes:

Andrew,

Thank you for your comprehensive explanation.

Do you have any suggestions if I still have any questions after I try to digest it all?

Thanks, Don

Andrew writes:
Pharmaceutical companies enjoy unprecedented profit margins that come at the expense of consumers. As a sector, the pharmaceutical industry enjoys the status of being the most profitable sector in the entire country.

A few points to respond:

Any company that makes a profit does so because their customer has traded money for some good or service. This applies to every industry from drugs to organic groceries. This should not be a suprise and is hardly worth posting. The key factor that most people forget is that anyone selling anything will not be able to get a customer to pay more for a product than that customer's precieved worth of the product. If Lipitor was priced at $100 per tablet many people would not consider the reduced risk of a heart attack worth $100 per day. However at the current going rate of about $2.50 per tablet many people do consider the reduced risk of a heart attack to be worth more than $2.50 and as a result they get their prescription filled month in and month out. The bottom line with this product as any other is that if you don't like the price, don't buy the product.

While scientists are central to developing innovative medications, they’re under compensated compared to the Corporate Executive Officers that do nothing to contribute to scientific breakthroughs. Regardless of their lack of scientific contribution, pharmaceutical CEOs banked like there’s no tomorrow! For example, in 2000, the CEO of Pfizer deposited $40.1 million into his piggy bank. Merck’s Executive VP strenuously slaved for his $26.5 million. Merck’s President of the Americas looted $19.6 million from the company’s customers.

How do you know that CEOs do nothing to contribute to breakthroughs? All of the people within the organization contribute and some outside of the organization also play a role. Does the contractor who built the laboratory contribute? Yes. Does the janitor who ensures a clean work enviornment contribute? Yes. Does the tech support employee who maintains the computer systems and data contribute? Yes. If the only people who contribute are the scentists, why do these firms employ anybody other than scientists? Surely you must agree that a large amount of capital is required to bring a drug from discovery thru trials to market. The last time I checked, the research scientists were not the ones doing road shows to raise money. My point is that all of the people are contributing in their own way.

As far as CEO compensation compared to scientist compensation, these are internal business decisions that are not directly related to the price of the product. The company obiously needs a certain number of scientists of various specialties and must pay the market rate for these people or else they will be unable to fill these positions. The company also needs a CEO and various other members of upper level management. Just like scientists there are a limited number of people qualified to run a business of the size and complexity of most major drug companies and the firm must pay the going rate for these people too. Even if the CEO was paid $50,000/year, there would still be no reason for them to reduce the price of their products to consumers or raise the salaries of scientists. The salaries of the CEO and other members of upper level management come out of the profits available to shareholders. This is the case for drug companies and all other businesses. If you don't like the CEO's salary buy enough shares to replace (or influence) the Board of Directors.

Even if price controls were introduced that capped drug prices at 90% of their current value, the pharmaceutical sector would still remain America’s most profitable. I really believe the time has come to aggressively negotiate for lower Rx prices. If Medicare were to stop carrying a certain prescription drug, such as a cholesterol lowering medication, it could potentially ruin a company’s performance. I don’t think Pfizer would ever consider telling Medicare to “screw off.” If Medicare and Medicaid were consolidated into a single negotiating authority, any company that told the public health system to “screw off” would be basically bankrupted.

(You may be aware of Medicaid pricing and rebates already so forgive me if I am telling you something you already know.)

There is a growing list of companies that have refused to bend to Medicaid demands (which does try to control prices paid thru rebate requirements) and as such these drugs are either unavailable to Medicaid patients or they are paid for at the rate set by the manufacturer, not Medicaid. Even if Medicaid and Medicare did combine for purposes of negotiations, they would represent about 50% of the market. I understand why people want Medicare to negotiate, but I don't think 50% enough to bankrupt anyone. You cannot honestly state that pharmaceutical companies are the most profitable companies in the world and then state that they would be bankrupted without Medicare coverage.

My prediction is that if Medicare does gain the right to negotiate they will end up eliminating coverage for certain drugs and the very next month congress will have an angry mob of senior citizens who want to know why their Lipitor was covered last month but not this month. Then instead of charging $2.50 per tablet, Pfizer will offer Medicare the bargain price of $3.50 or $4.00 per tablet and Medicare will pay it.

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