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How Increased Competition from Generic Drugs Has Affected Prices and Returns in the Pharmaceutical Industry July 1998

At the same time that the provisions of the Hatch-Waxman Act have affected the supply of generic drugs, changes in the demand for drugs--brought on by newer forms of health care delivery and financing--have influenced both the frequency with which generic and brand-name drugs are prescribed and the prices paid for them. Under competitive pressures, more health plans have adopted managed care techniques that help hold down overall health spending. The net effect of those techniques on prescription drug spending, however, is unclear.

The wider use of formularies has put downward pressure on the prices paid for brand-name drugs and has increased generic substitution. But use of prescription drugs may be higher in health maintenance organizations and some other types of managed care plans, because they tend to have more extensive coverage of physicians' services and sometimes of prescription drugs. In addition, managed care plans may sometimes favor the use of prescription drugs over other, more expensive, forms of medical treatment. As a result, the downward pressure on prices from the spread of managed care techniques may be offset by the more frequent use of prescription drugs.
 

The Rise of Managed Care

The shift of many people in the United States from conventional to managed care plans has been associated with an increasingly competitive market for health insurance, in which plans compete largely on the basis of price to maintain their market share. Managed care plans enjoy an advantage because they can generally charge lower prices than conventional insurance plans by negotiating better rates from doctors, hospitals, and other health care providers and by reducing the use of high-cost services. Because of that cost advantage, a large number of people have moved to managed care plans. According to the Bureau of Labor Statistics, the proportion of full-time workers with health insurance who were enrolled in such plans increased from around 26 percent in 1988 to 61 percent by 1995.⁽¹⁾ As a result, the cost of health care benefits for the private sector has grown more slowly in recent years (although it may now be on the rise again, with some health plans anticipating significant increases in 1999).⁽²⁾

In conventional health insurance plans--also known as indemnity, or fee-for-service, plans--enrollees can receive care from any physician or hospital they choose. Generally, they must pay for some initial amount of health care spending themselves (the deductible) and pay an additional amount (a copayment) of any costs beyond that. Conventional plans pay health care providers on a fee-for-service basis.

In managed care plans, by contrast, beneficiaries are encouraged to use a limited network of health care providers. The extent of that limitation, or the conditions under which a patient may choose a doctor or hospital outside the plan's network, can be used to broadly categorize the various types of managed care plans.⁽³⁾

• Health Maintenance Organizations. Enrollees in an HMO must generally receive all of their care from the HMO's physicians and from hospitals with which the HMO contracts; otherwise, the expense is not covered. The services they receive from those physicians are typically covered in full, apart from a flat dollar copayment for an office visit. (Copayments may also be required for such items as prescription drugs.) The plan's health care providers often bear some financial risk for the costs of the services they furnish or order on behalf of their patients.
  
  
• Preferred Provider Organizations. Enrollees in a PPO can receive services from any provider they choose, but typically they incur significantly lower deductibles and copayments if they use physicians and hospitals that are part of the PPO's network. The PPO pays providers in the network on a fee-for-service basis. Unlike in conventional insurance plans, however, those fees are subject to negotiation between providers and the plan.
  
  
• Point-of-Service Plans. POS plans are also known as HMO/PPO hybrids or open-ended HMOs. As in a PPO, enrollees can choose to receive services from providers who are not members of the plan's network as well as from those who are members. When enrollees use network providers, a POS plan functions much like an HMO. When they use other providers, by contrast, those providers are typically paid on a fee-for-service basis and enrollees are responsible for deductibles and copayments.

Many managed care plans transfer financial risk to physicians and other health care providers through the various financial arrangements they use to reimburse those providers. For example, some managed care plans use a form of capitation to reimburse physicians. In such cases, the physician (or group of physicians) is paid a fixed monthly amount per enrollee and is responsible for providing all primary care services--and in some instances, for paying for all medical services, including the use of specialists. When providers are at financial risk for the services they furnish or order for patients, they have a powerful incentive to provide less costly care. The net effect of that incentive on prescription drug use is not certain. But it could encourage providers to prescribe drugs in more cases rather than immediately selecting relatively expensive, procedure-oriented approaches.

An important trend in the spread of managed care techniques is that most types of health care plans--including conventional fee-for-service plans--have increasingly been "managing" their outpatient prescription drug benefits, frequently through pharmaceutical benefit management companies. Since 60 percent of prescription drugs are sold through pharmacies and other retail outlets, PBMs have become an important intermediary that helps limit costs for those drugs.
 

How PBMs Help Hold Down Drug Expenditures

Pharmaceutical benefit management companies exert downward pressure on the prices paid to both manufacturers and pharmacies. In return for channeling their patient base to particular pharmacies, they arrange to pay lower retail prices for drugs at those pharmacies. Similarly, PBMs are able to negotiate rebates from manufacturers of brand-name drugs based on their ability to steer their members toward a particular drug by using a formulary.⁽⁴⁾ Those cost-saving methods are not limited to PBMs; some health insurers have set up similar operations to manage their own drug benefits. HMOs that have on-site pharmacies also apply formularies to promote the use of specific drugs and to negotiate rebates from drug manufacturers.

How Formularies and PBMs Operate

Typically, in a retail setting, formularies work as follows: a customer gives a prescription to a pharmacist to be filled and presents a membership card in a health insurance plan or PBM. The pharmacist then uses a computer network to check the plan's or PBM's list of preferred drugs as a guide in filling the prescription. Such lists frequently specify substituting a generic drug for a brand-name drug (something that has only been legal in most states since the late 1970s; see Box 2). In some cases, formularies also suggest substituting a less expensive brand-name drug for the one on the prescription. Promoting substitution between brand-name drugs is more difficult, however, since it requires the doctor's permission.
 

Using the same computer network, a PBM can track all prescription drug purchases by its members from pharmacies--providing it with a wealth of market data. PCS Health Systems, the largest PBM in the United States, in 1987 established the first electronic links with pharmacies that allowed two-way transmission of information and claims data.⁽⁵⁾ PBMs never physically handle prescription drugs. Rather, they act as middlemen in a variety of transactions with health plans, pharmacies, and drug companies and thus insert themselves into the payment system (see Figure 1).
 

Figure 1. How PBMs Fit Into the Payment System for Prescription Drugs

SOURCE:Congressional Budget Office based in part on General Accounting Office, Pharmacy Benefit Managers: Early Results on Ventures with Drug Manufacturers, GAO/HEHS-96-45 (November 1995).

NOTE: PBMs = pharmaceutical benefit management companies.

PBMs have found their niche as health insurance plans have expanded outpatient drug benefits. In 1972, just 20 percent of total retail drug spending was paid for by third parties (such as private-sector health plans or Medicaid). By 1995, that figure had tripled to 60 percent.⁽⁶⁾ What share of those drug benefits is being managed by PBMs or health plans themselves is unclear, but it appears to be significant. According to IMS America, a company that supplies sales data on the pharmaceutical industry, 58.5 percent of retail pharmacies' revenues from drug sales in 1996 came from prescriptions that were at least partly paid for by third-party managed care drug coverage.⁽⁷⁾ (That figure does not include cases in which patients paid for the entire prescription because they had not yet met their plan's deductible or the prescription price was less than their copayment, although in such cases the drug benefit may also be managed.) IMS America's definition of managed care third-party payment requires that customers presented an electronic card to the pharmacist indicating their membership in a health plan.⁽⁸⁾

Manufacturer Rebates and Pharmacy Prices

Much of the savings that PBMs achieve appear to come from the lower prices paid to pharmacies rather than from the rebates offered by drug manufacturers. The General Accounting Office studied three large health plans for federal employees that used both PBMs and mail-order pharmacies. The study found that 50 percent to 70 percent of the drop in the plans' spending on prescription drugs resulted from lower retail prescription prices (lower than what the plans would have paid at the pharmacy's usual and customary charge). Two percent to 21 percent of the savings resulted from manufacturer rebates that the PBMs shared with the health insurance plans.⁽⁹⁾

Generic Substitution

Another important way that PBMs lower drug costs is by promoting generic substitution, not just through formularies but also through their pricing contracts with pharmacies. In general, dispensing a generic drug is already slightly more profitable for a pharmacist than dispensing a brand-name drug.⁽¹⁰⁾ PBMs' contracts sometimes provide financial incentives that make generic substitution even more profitable for pharmacists.

PBMs can also encourage generic substitution at the consumer level. In a conventional health plan, prescription drug coverage reduces the gap between the prices of brand-name and generic drugs as seen by the consumer. For example, if an innovator drug costs $40, its generic equivalent costs $20, and a health plan has a 20 percent copayment, then the consumer's price comparison is between $8 for the brand-name drug and $4 for the generic drug (after any deductible has been met). Because that price difference is small, the consumer may believe that the brand-name drug is worth an extra $4 and may prefer to have it dispensed. Many PBMs and health plans that manage their own drug benefits try to widen that price gap by charging a higher copayment for nonformulary drugs, such as brand-name drugs chosen over generic substitutes.⁽¹¹⁾

Some researchers have found that even a small difference in the copayment can encourage generic substitution. One study determined that HMOs with a copayment difference of at least $2 between brand-name and generic drugs had as high a rate of generic substitution as HMOs that explicitly required such substitution.⁽¹²⁾

Industry Changes

Some analysts question whether the savings that PBMs produce will be adversely affected by recent changes in the industry. Several of the largest PBMs have been acquired by pharmaceutical manufacturers. PCS was bought by Eli Lilly in 1994 for $4 billion; Medco (both a PBM and a mail-order pharmacy) was acquired by Merck in 1993 for $6.6 billion; and Diversified Pharmaceutical Services was purchased by SmithKline Beecham in 1994 for $2.3 billion.⁽¹³⁾ With acquisition, will those PBMs continue to represent the interests of insurance plans and patients effectively? Or will they have an incentive to favor their parent company's drugs over others?⁽¹⁴⁾ The FDA has begun to regulate the advertising and marketing practices of PBMs owned by pharmaceutical manufacturers.⁽¹⁵⁾ The Federal Trade Commission is also looking into those issues.

Another change in the industry involves the growing proportion of drugs distributed through mail-order pharmacies. Many insurance plans now include an option to purchase drugs by mail. According to IMS America, between 1991 and 1996 the share of prescription drugs channeled through mail-order pharmacies grew from 6 percent to 10 percent of manufacturers' total sales revenues.⁽¹⁶⁾ Mail-order pharmacies are able to obtain substantial discounts on brand-name drugs from manufacturers in part because, in a mail-order setting, pharmacists have more time (about two days) to contact doctors and obtain permission to switch a prescription to a less expensive brand-name drug.⁽¹⁷⁾ In addition, mail-order pharmacies appear to be more effective in promoting generic substitution than retail pharmacies.⁽¹⁸⁾ Also, drugs ordered through a mail-order setting are frequently for chronic conditions, so the savings from switching the prescription are greater since the drug will be taken for a long period of time.

In addition, links have developed between PBMs and mail-order pharmacies. In 1996, PCS Health Systems, the largest PBM, opened a mail-order pharmacy; and the largest mail-order pharmacy, Medco, also has a PBM business.

In sum, the increasing management of outpatient drug benefits has put downward pressure on prescription drug costs by lowering the average prices that both manufacturers and pharmacists receive for those drugs. The promotion of generic substitution has also been a key factor in holding down the average price of prescription drugs (and is something that is more easily accomplished in a pharmacy setting than favoring one brand-name drug over another).
 

How Managed Care Affects the Demand for Prescription Drugs

To encourage people to enroll in managed care plans and accept a limited network of providers, such plans typically charge lower copayments for physician visits and other medical services (when the limited network is used) than traditional fee-for-service plans do. Those lower copayments tend to increase the use of physicians' services, which in turn increases the demand for prescription drugs.⁽¹⁹⁾ HMOs generally also have more extensive prescription drug coverage than most fee-for-service plans. According to a 1993 survey by the Bureau of Labor Statistics, HMOs typically charged $3 to $5 for a prescription drug purchase, with no deductible, compared with a 20 percent copayment and a deductible (covering all medical services) in most fee-for-service plans.⁽²⁰⁾ Those lower prescription costs to the patient may increase the proportion of prescriptions that are actually filled. Indeed, some drug manufacturers believe that HMOs have contributed to the increase in the volume of prescription drug sales.⁽²¹⁾

A study by researchers at RAND suggests that a lower copayment structure for both physician visits and prescription drugs boosts the use of such drugs. The study randomly enrolled people in various fee-for-service plans that differed primarily in their coinsurance rates and deductibles. After adjusting for differences in population characteristics, the authors concluded that annual prescription drug spending per person was one-quarter less in plans with a 25 percent coinsurance rate, no deductible, and a $1,000 cap on out-of-pocket expenditures than in plans in which all medical services were free. When the coinsurance rate was increased to 95 percent, drug spending per person was 43 percent lower than when all services were free.⁽²²⁾ Those results suggest that the smaller copayments and absence of deductibles for prescription drugs and physicians' services that are typical of many managed care plans lead to greater use of prescription drugs.⁽²³⁾

Moreover, a later study found that more prescriptions were bought per person in several HMOs than in a fee-for-service plan that offered comprehensive prescription drug coverage.⁽²⁴⁾ The fee-for-service plan, like the HMOs, required only a small copayment for prescription drugs and no deductible. In the three cases in which age adjustment was possible, the HMOs nevertheless had 5 percent to 20 percent more prescriptions dispensed per beneficiary than the fee-for-service plan. That result suggests that the treatment practices of HMOs may favor more intensive use of prescription drugs than the procedures of fee-for-service plans do, perhaps as an alternative to costlier forms of treatment. (However, the study did not mention the copayment structure for physicians' services in the HMOs and fee-for-service plan. If the HMOs had lower copayments for physicians' services, that could partly explain their higher volume of prescription drug use.)

The same study also found that the HMOs used newly approved drugs as much as the fee-for-service plan. They showed no tendency toward a slower diffusion of new innovative drugs. The percentage of prescriptions that were dispensed for a newly approved brand-name drug was the same for the two types of plans. Since the overall quantity dispensed was higher in the HMOs, that implies a slightly higher use of all drugs, including new brand-name ones.
 

Conclusions

Although some managed care techniques put downward pressure on drug spending by lowering the prices paid for brand-name drugs and promoting generic substitution, other techniques, such as lower copayments for health care services, tend to increase prescription drug use and total drug spending. It is not clear how the increased use of those techniques has affected the net returns from marketing a new drug. PBMs appear to have greater success at negotiating discounts from retail pharmacies than from drug manufacturers (in the form of rebates). Thus, the management of outpatient drug benefits may not have hurt drug companies' returns very much. And the movement of beneficiaries into managed care plans may have had a positive effect on prescription drug use. If managed care has helped increase the use of prescription drugs, which are often less costly than other forms of treatment, then the somewhat lower prices may be at least partially offset by a rise in the quantity of prescription drugs sold.

Those opposing trends (lower prices but higher demand) make it difficult to determine whether total spending on brand-name prescription drugs has increased or decreased because of the rise of managed care techniques--and as important, whether the total profits of those drugs' manufacturers have risen or fallen as a result.

For brand-name drugs still under patent, the effect of managed care on spending could be negligible if the discounts that purchasers obtain are offset by a higher quantity sold. However, since managed care techniques promote generic substitution, their effect on spending and profits is probably negative for brand-name drugs whose patents have expired.

1. Those figures are for employees of medium to large firms; see Department of Labor, Bureau of Labor Statistics, "BLS Reports on Employee Benefits in Medium and Large Private Establishments, 1995" (press release, July 25, 1997, available at http://www.bls.gov/ncs/ebs/sp/ebnr0003.txt).

2. See Congressional Budget Office, Trends in Health Care Spending by the Private Sector, CBO Paper (April 1997); and Mercer/Foster Higgins, National Survey of Employer-Sponsored Health Plans (New York: Mercer/Foster Higgins, 1997).

3. The definitions below come from Congressional Budget Office, Trends in Health Care Spending by the Private Sector. That paper relied in part on a survey on employer benefits by KPMG Peat Marwick to develop those definitions; see KPMG Peat Marwick, Health Benefits in 1995 (August 1995), p. 10. Many health insurance providers refer to their different insurance arrangements as products ("indemnity product," "point-of-service product," and the like). More than one product may be available from a particular provider to a company or individual enrollee. To be consistent with the earlier CBO paper, this study uses the term "plan" to refer to those products.

4. See, for example, "PCS Rebates from Pfizer on Seven Products Totaled over $10 Million in First 21 Months of 1994-1998 Contract," The Pink Sheet, F-D-C Reports, June 10, 1996, p. 16.

5. Wilbur B. Pittinger, Senior Vice President for Health Management Services, "Placing PBMs in Context" (keynote address given at the roundtable conference of the Tufts Center for the Study of Drug Development, "PBMs: Reshaping the Pharmaceutical Distribution Network," October 24, 1996, available at http://www.pcshs.com/ news/speeches/102496.html).

6. James S. Genuardi, Jean M. Stiller, and Gordon R. Trapnell, "Changing Prescription Drug Sector: New Expenditure Methodologies," Health Care Financing Review (Spring 1996), p. 192; and Katherine R. Levit and others, "National Health Expenditures, 1995," Health Care Financing Review, vol. 18, no. 1 (Fall 1996), p. 185.

7. IMS America, "IMS Reports Major Regional Differences in Managed Care Growth" (press release, April 14, 1997, available at http:// www.ims-america.com/communications/pr_regional.html).

8. Personal communication by Paul Wilson, Vice President of Statistical Services, IMS America, on March 1, 1998. If a customer had health insurance but applied for reimbursement later rather than presenting a card at the pharmacy, the transaction was considered a cash payment. Cash payments totaled 29.3 percent of pharmacies' drug revenues. Medicaid payments made up the remainder.

9. General Accounting Office, Pharmacy Benefit Managers: FEHBP Plans Satisfied with Savings and Services, but Retail Pharmacies Have Concerns, GAO/HEHS-97-47 (February 1997). In addition, Blue Cross found that in partnership with PCS Health Systems, it saved more on prescription drug expenditures through pharmacy discounts than through rebates from manufacturers (presentation by Alan Spielman, Vice President for Business Services, Blue Cross and Blue Shield Association, at the National Health Policy Forum "Purchasing as a Cost-Containment Tool: A Look at Pharmacy Benefit Management," Washington, D.C., May 12, 1995).

10. For most multiple-source drugs, the markup over the wholesale cost is higher (on an absolute dollar basis) for generic drugs than for brand-name drugs. In addition, because their wholesale cost is lower, the cost of having money tied up in stocks of generic drugs is lower. According to a recent study, for a prescription of 100 pills, the average retail markup on a generic prescription was about $13, compared with $10 on a brand-name prescription; see Henry Grabowski and John Vernon, "Longer Patents for Increased Generic Competition in the U.S.: The Hatch-Waxman Act After One Decade," PharmacoEconomics (1996), p. 116, Table IV.

11. See General Accounting Office, Pharmacy Benefit Managers: Early Results on Ventures with Drug Manufacturers, GAO/HEHS-96-45 (November 1995), p. 7. That report refers to formularies that charge a higher copayment for nonformulary drugs as "incentive based" formularies. Other insurers, including many HMOs, have a very small copayment difference between brand-name and generic drugs and therefore rely more on their doctors and pharmacists (rather than price) to promote generic substitution; see Levit and others, "National Health Expenditures, 1995," p. 185.

12. Jonathan P. Weiner and others, "Impact of Managed Care on Prescription Drug Use," Health Affairs (Spring 1991), p. 145.

13. See Milt Freudenheim, "Pharmaceutical Giant Is Buying Operator of Drug-Benefit Plans," New York Times, July 12, 1994, p. A1. For a ranking of PBMs by size in 1994, see Milt Freudenheim, "A Shift of Power in Pharmaceuticals," New York Times, May 9, 1994, p. D1.

14. See General Accounting Office, Pharmacy Benefit Managers: Early Results on Ventures with Drug Manufacturers.

15. See Bruce Ingersoll, "FDA to Watch Drug Switching, Sales Practices," Wall Street Journal, January 16, 1998, p. B1.

16. For the 1991 figures, see "Mail Order Grew 37 Percent to $2.9 Billion in 1991 IMS Survey: Growth May Slow Soon," The Pink Sheet, F-D-C Reports, March 16, 1992, p. 11. For the 1996 figures, see Pharmaceutical Research and Manufacturers of America, 1997 Industry Profile (Washington, D.C.: PhRMA, March 1997), p. 31.

17. For a discussion of how Medco obtains discounts from manufacturers, see Brian O'Reilly, "Medco Containment Services," Fortune, February 24, 1992, p. 10. See also Thomas M. Burton, "Eli Lilly's Lack of Success with PCS May Soon Lead to a Major Write-Off," Wall Street Journal, June 5, 1997, p. A3.

18. In 1992, Medco dispensed a generic drug on 72 percent of prescriptions for a multiple-source drug; statement of Judith L. Wagner, Office of Technology Assessment, before the Senate Special Committee on Aging, November 16, 1993.

19. See Congressional Budget Office, Updated Estimates of Medicare's Catastrophic Drug Insurance Program (October 1989), p. 47, for a discussion of the relationship between physicians' services and prescription drug expenditures.

20. Department of Labor, Bureau of Labor Statistics, Employee Benefits in Medium and Large Private Establishments, 1993, Bulletin 2456 (November 1994), p. 44 and Tables 64, 66, 85, and 86. The full results from the bureau's 1995 survey have not yet been published.

21. See Levit and others, "National Health Expenditures, 1995"; and IMS America, "IMS Says Managed Care Drove Unprecedented Growth in Pharmaceuticals in 1996" (press release, April 14, 1997).

22. Arleen Leibowitz, Willard G. Manning, and Joseph P. Newhouse, "The Demand for Prescription Drugs as a Function of Cost-Sharing," Social Science Medicine, vol. 21, no. 10 (1985), pp. 1063-1069, Table 4. See also Willard G. Manning and others, "Health Insurance and the Demand for Medical Care: Evidence from a Randomized Experiment," American Economic Review (June 1987), pp. 251-277.

23. The results of the RAND study do not indicate whether physician coverage or drug coverage has a greater effect on the quantity of prescriptions sold.

24. Weiner and others, "Impact of Managed Care on Prescription Drug Use," pp. 141-153. The HMO plans in the study did not employ their own doctors, but instead contracted with doctors that also had their own private practice.

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