This appendix describes the healthcare market in the USA. The US experience contains useful lessons for other countries regarding market-driven provision of healthcare and the relationship between the public and the private sector. Germane to this report are:

• the US experience with tendering for bulk purchasing of pharmaceuticals between large healthcare plans and manufacturers;
• the effects of the use of legislation and other policy instruments to make generic entry easier and less costly;
• the increasingly important use of IT to track products and purchasing decisions through the chain, which allows for sophisticated monitoring and data for economic analysis.

Section A7.1 gives a brief history of the USA’s health market. Section A7.2 covers US healthcare expenditures. Section A7.3 describes the role of some of the major players in the provision of healthcare. Section A7.4 gives an overview of the contractual relationships between these players and the pharmaceutical industry. Section A7.5 examines the US pharmaceutical industry as a whole, and section A7.6 deals with the US generic drug market.

Health spending in the USA has increased significantly over the past few decades. From $27 billion in 1960, it grew to $898 billion in 1993, increasing at an average annual rate of over 11%. In 1998 average healthcare expenditure per person was $4,094, up from $141 in 1960. This growth has given the healthcare sector a large share of the overall economy. Health expenditures were 5.1% of GDP in 1960 and rose to 13.7% of GDP in 1993. The US is comparable with other industrialised countries in terms of its percent of GDP spent on pharmaceuticals. For example, although the UK spends considerably less per capita on pharmaceuticals ($251 in the UK versus $408 in the USA), it spends a similar percent of GDP on pharmaceuticals (1.3% in the UK and 1.4% in the US). Total prescription sales for the US pharmaceutical market in 1998 were approximately $94 billion, accounting for around 2.6 billion prescriptions.

The annual percentage increases in prescription expenditures have surpassed most other components of health spending. Increased expenditures are influenced by increases in price and utilisation, and changes in the type of prescriptions used. Price rises have contributed less (18%) to increased expenditure than increased utilisation (43%) and changes in the type of drugs used (39%), with newer, more expensive, drugs typically replacing older drugs with the same therapeutic benefits. Between 1995 and 1998 prescription expenditures grew nearly 50%, while expenditures for physician services rose by 14% and for hospital care by 10%.

The increased expenditure on pharmaceuticals can also be illustrated in the growth in pharmaceutical sales and in the number of pharmaceutical prescriptions dispensed.

Source: IMS Health for GPIA/www.gpia.org

Table A7.1 shows that the total prescription drug sales increased from $54.3 billion in 1993 to $94 billion in 1998.

These growth trends are expected to continue, especially with the increasing use of managed care, which favours intensive use of prescription drugs. National health expenditures are projected to total $2.2 trillion in 2008, growing at an average annual rate of 6.5% from their level in 1997. Healthcare is expected to increase to 16.2% of GDP by 2008. This trend is likely to place renewed pressure on public- and private-sector payers to search for additional ways to constrain costs. National health expenditures for pharmaceuticals are projected to reach $243 billion in 2008.

Overall, the US pharmaceutical market is not overly concentrated. The top branded drugs manufacturers according to total pharmaceutical sales each account for no more than 7% of the entire market for prescription drugs. However, this changes when it is divided into narrowly defined therapeutic classes. Within 35 of the 66 therapeutic classes of drugs studied by the US Congressional Budget Office in 1998, the top-three innovator drugs together constituted at least 80% of retail pharmacy sales in their class.

A7.2.1 Size and structure

In the USA, estimates predict that generics will grow to account for 15% (by value) of the US pharmaceutical market by 2005.

In 1997/98 the US generics market was valued at $8.6 billion. Although a large share of the total pharmaceutical market, the US generics sector relative to all pharmaceutical expenditures ranks fairly low among OECD countries (eight European countries have a higher generics share.) In fact, many of the major generics firms in the USA are subsidiaries of larger R&D-based companies with European principals. For example, Eli Lilly, Hoechst Marion Roussel, Rhone-Poulenc Rorer, Pharmacia & Upjohn, SmithKline Beecham, and AstraZeneca all have generics operations in the USA.

The five largest generics companies in the USA, including the independents and those with research-based affiliates, command a share of about 30% of the generics market. This suggests concentration but not dominance in supply. The role of the research-based affiliates appears to be larger in the USA than in most of Europe. Of the leading research-based multi-nationals, 12 have a generic subsidiary in the USA.

The US generics market has seen steady growth over the last decade, and this trend is forecast to continue in the immediate future. Figure A7.1 shows the sustained growth of the generic market share of all US prescription drugs. Since 1984, the generics share of all US pharmaceuticals has grown substantially, from an 18.6% market share of all US prescription drugs in 1984, to 40–43% in the late 1990s.

Source: IMS Health, www.gpia.org.

Three factors have been identified as contributing to the growth of the generics sector:

• the Hatch–Waxman Act 1984 facilitated entry into the generics market;
• the drug substitution laws passed by most states in the 1980s allow pharmacists to dispense a generic drug, even when a prescription calls for a brand name;
• the rise of managed care and the effects of government, as well as private health-insurance plans actively promoting generic substitution for branded drugs, have contributed to the growth in generic drug use.

The proportion of prescriptions dispensed as generic drugs increased from 33% to almost 45% during the 1990s. However, the percentage of total pharmaceutical sales owing to generics has declined since 1996. Sales of generic drugs do not keep pace with those of branded drugs, even as they increase their market share owing to the changing mix of branded drugs with increasingly higher prices. That is, older drugs are being replaced with newer and more expensive branded drugs.

Branded medicines compete with other branded medicines in terms of quality and advertising. Generics, on the other hand, compete with branded medicines and other generics by lowering prices. Figure A7.2 shows that the price of branded drugs has risen steadily from 1994 to 1998, whereas the average price per script of generic drugs has fallen from 1994 to 1998.

The Hatch–Waxman Act 1984 eliminated the need for duplicative testing of generic substitutes for branded drugs in order to obtain FDA approval. After 1984, generic drugs only had to establish bioequivalence with the innovator drug. Prior to that, they also had to demonstrate therapeutic and clinical efficacy. In addition, the new policy allowed production and testing of generic products to begin prior to expiration of the innovator’s patent. This change made generic entry much less costly than previously, and reduced the average delay between patent expiration and generic entry from three or more years to less than three months.

Perhaps even more importantly, the Hatch–Waxman Act increased the proportion of branded drugs facing generic competition when their patents expire. In 1983, only 35% of top-selling drugs with expired patents were facing generic competitors, now nearly all must face generic competitors.

When launched at the time that a patent lapses, a generic drug is usually priced at around 30% less than the original branded drug. By the time there are five or six generic entrants, the prices fall to 60–70% less than the original branded drug. From this it can be seen that facilitating generic entry, as the Hatch-Waxman Act accomplished in 1984, has placed significant downward pressure on pharmaceutical prices, generics and overall.

The lower average price of generic medicines has led to an increase in their use. Figure A7.2 above showed that, although the use of generics in terms of total prescriptions dispensed is on the rise, the proportion of generics in the total sales figures of pharmaceuticals is no longer increasing. This is explained by the fact that the increased use of generics is forcing average prices of generics down. Therefore, greater generic prescribing will not result in a significant rise in total sales figures if generic prices overall are still falling. Here, the increased competition from the Hatch–Waxman Act is proving to exert downward pressure on prices of generics. In theory, this increased competition ought to exert downward pressure on the price of branded medicines as well.

A Congressional Budget Office study of 21 branded drugs that first saw generic competition between 1991 and 1993 showed that, within 12 months of patent expiration, the branded drugs lost an average of 44% of market share to generics. On average, the generics in this study cost 25% less than the branded equivalent at retail prices. It appears therefore that the generic drugs are threatening the branded drugs by taking market share. Thus far, this does not seem to have had much of a dampening effect on retail prices. However, it has had a significant effect on the deals negotiated by discount buyers such as PBMs and HMOs. As mentioned above, best-price discounts for bulk buyers of branded drugs are much lower when generic substitutes are available.

One effect of this loss of market share to generics is a decline in the returns on innovation. The Congressional Budget Office estimates that expected returns to marketing a new drug fell about 12% between 1984 and 1997, mainly owing to the increased competition from generic equivalents. Nevertheless, even with decreasing returns, expenditure on R&D continues to rise steadily. In 1975, $1.1 billion was spent on R&D, but this has increased up to $4.1 billion in 1985, $8.4 billion in 1990, $15.2 billion in 1995 and $21.1 billion in 1998.

In the USA individuals either have private medical insurance through their employer, receive government health insurance in the form of Medicare or Medicaid, or are not covered by health insurance.

The details of the operation and organisation of HMOs are detailed below, but one of the key features, and which has proved contentious, is the use of Diagnostic Related Group (DRG) guidelines and formularies. These restrict the procedures that doctors can use and the drugs that are supplied to patients. Both have been unpopular with doctors and patients alike; doctors prefer to prescribe medicines and diagnose procedures solely according to professional judgement, and patients have expressed concern that HMOs hold profits as a higher priority than patients’ needs and quality of care. To address these concerns, the Patients Bill of Rights attempts to preserve patients rights while allowing health-insurance companies to act in a cost-effective manner.

Within the US healthcare market since the early 1990s there has been an overall trend towards consolidation. In particular, there has been an attempted merger of the top-four national wholesalers into two groups, and the increasing size of HMOs with wide geographical coverage has led to the establishment of large retail pharmacy networks. Similarly, a significant proportion of US hospitals have become members of large health system networks, called integrated delivery networks (IDNs). These large networks include member hospitals, doctors’ surgeries, nursing homes, and other healthcare facilities that are connected through ownership or some other affiliation. As many as 90% of hospitals are now involved in some sort of IDN, and they contract their services as a healthcare package to HMOs or other providers.

Employers offer a menu of insurance contracts that embody different health benefits, but also involve increasing levels of employee contribution. The employer arranges and purchases the appropriate healthcare coverage from a private-sector insurance provider, usually a managed-care health plan or HMO. In this way, employers are the purchasers of healthcare, but managed-care firms organise the actual provision of the care. In the case of government provision, individuals covered by Medicare or Medicaid sign up through the state or local government agency.

Managed-care organisations or HMOs contract with healthcare providers, such as pharmacy networks, doctors, hospitals and hospital networks. These arrangements involve reimbursement schemes that depend on the care providers adhering to guidelines determined by the managed-care organisation. The guidelines usually include DRG guidelines for procedures and a formulary of reimbursable drug preparations and brands for pharmaceuticals.

Health-plan members, and those with Medicare entitlement, usually make a contribution towards the cost of prescription or hospital treatment. For prescriptions this copayment is small, around $5–10, but this figure can rise to several hundred for hospital operations. Those without health-insurance coverage, or private or government aid, are forced to pay retail prices.

In this way, the use of the formulary allows health plans and PBMs to manage the prescription use of patients as well as the prescribing patterns of specific doctors and the dispensing behaviour of the pharmacists. The PBM or health plan is also able to negotiate low prices from manufacturers in return for a place on the formulary.

As mentioned above, large managed-care organisations have become the main providers of private health insurance in the USA. HMOs are characterised by an approach to healthcare that aims to provide at constraining cost, and, as such, they manage to offer lower premiums than are available from private indemnity-insurance plans.

Most HMOs arrange the supply of their healthcare through PBMs, which are selected on the basis of cost and the extent of their pharmacy network. PBMs also negotiate hospital care on behalf of the HMO, although some HMOs are vertically integrated, owning their hospitals. In essence, therefore, many HMOs are little more than financial organisations with healthcare expertise. The main exception to the arm’s-length relationship between the managed-care organisation and the healthcare provision is Kaiser Permanente. Kaiser is completely vertically integrated, owning the hospitals, pharmacies and distribution facilities. Through its subsidiary, Permanente Medical Group, it also has an arrangement with its doctors.

The principal benefit to Kaiser of the vertical integration is the alignment of objectives throughout the network. All elements within the healthcare provision chain are involved in, and benefit from, the various measures taken to reduce costs and improve clinical performance. Through this communal approach, Kaiser achieves very high compliance rates to its group initiatives, such as 99% generic prescribing.

Many HMOs have instituted DRG guidelines for physicians and hospital providers, limiting the type and number of procedures that will be reimbursed for a patient with a given diagnosis. The administration of managed care involves physicians keeping coded records for HMOs which report the procedures used and demonstrate compliance with the DRG guidelines. Without compliance, no reimbursement is made. In this way, HMOs try to induce physicians to consider cost efficiency within the scope of their professional judgements. Those HMOs that use PBMs inform the PBM of the formulary and DRG restrictions that are to be used for the various health plans offered by that HMO.

Preferred provider organisations (PPOs) are managed-care organisations. They are administered in a similar way to HMOs, except that a PPO allows patients more choice of doctor or healthcare provider. Where HMOs only reimburse patients’ visits to certain physicians or healthcare facilities, PPOs will reimburse fully for those specified preferred providers with whom they contract, but will reimburse partially (perhaps 60–80%) for alternative sources of treatment that the patient may decide to use.

PBMs are the operational element of the managed-care system. In effect, HMOs sub-contract the operation of pharmaceutical benefits for their healthcare plans to PBMs, which organise the provision of pharmacy services. Some PBMs contract with large employers, while some HMOs internalise the PBM function. PBMs manage information and payments between pharmacies and HMOs, and they operate a sophisticated database that informs pharmacists of every patient’s health-plan entitlements.

Through the aggregation of demand from many pharmacies and several HMOs, PBMs are able to negotiate lower prices for pharmaceuticals by offering manufacturers a place on the HMO/PBM formulary—ie, the list of reimbursable drug brands and preparations available for HMO members. This delivery of a market share of customers induces manufacturers to offer substantial price discounts to the managed health plans (largely in the form of rebates from manufacturers in return for delivery of some level of demand).

PBMs have developed in reaction to the needs of the managed-care sector, and now manage significant proportions of the market—in 1998, PBMs were processing about 40% of all prescriptions dispensed. The PBM market in that year was dominated by three firms which represented 64.2% of prescriptions processed by PBMs and 27.1% of all US prescriptions dispensed.

In addition PBMs collect information about drug prescribing, make predictions about the cost–benefit ratio of the use of specific products, and buy drugs in bulk for their clients. One important innovation from tracking pharmaceuticals through PBMs and formularies is the increased information made available by the electronic information networks. Health plans, PBMs and pharmacies all have access to a database of drug products prescribed and dispensed, which allows for the monitoring of specific information and data collection for economic and clinical performance analysis. Doctors’ adherence to guidelines other than the formulary or DRG can also be monitored, and initiatives implemented to improve areas such as the level of generic prescribing.

Since 1966, Medicare has covered most of the elderly, aged 65 or over. In 1973, disabled people and individuals with end-stage renal disease also became eligible, as well as certain otherwise non-covered elderly persons who elect to pay a premium for Medicare coverage.

Medicare consists of two parts: Hospital Insurance, or Part A, and Supplementary Medical Insurance, or Part B. Hospital Insurance covers in-patient hospital care, skilled nursing care and hospice care, and is generally provided automatically for all US citizens aged 65 or older. The latter covers out-patient services including physical therapy, radiation therapy and practitioners who are not doctors, such as registered nurses, clinical psychologists and social workers. It is offered on a voluntary enrolment basis to everyone covered by Hospital Insurance.

The Hospital Insurance programme is financed primarily through a mandatory payroll tax (approximately 1.45% of earnings) and the Supplementary Medical Insurance is financed through premium payments ($45.50 per beneficiary per month in 2000). Medicare is a federal health-insurance programme, although administration is often performed at the state level.

Medicare funds most of its benefit on a fee-for-service basis. It establishes fee schedules with doctors, hospitals and other providers on which it reimburses. These are fixed and set the maximum that doctors can receive if they accept a Medicare patient. If doctors do not accept the Medicare fee schedule, but treat the patient, the maximum they can charge is 15% above the Medicare price. These prices are set on a unit basis, for example, per day or per diagnosis, and there is a 20% patient copayment. For example, Medicare may state that a particular operation will be reimbursed at $1,500. If the physician accepts this rate, he or she will receive $1,200 from Medicare and the remaining $300 from the patient. If the doctor does not accept the Medicare rate, then the maximum he or she can charge is $1,500 + 15%, an increase of $225 which is borne entirely by the patient, whose copayment now rises to $525. Physicians can refuse an operation, but in doing so they remove themselves completely from the Medicare system and can never again accept a Medicare patient.

There has been considerable debate in Congress about extending Medicare to include out-patient prescriptions which are currently not included. This will cause considerable funding issues, as Medicare would then account for about 35% of total drug expenditure in the USA.

Medicare currently covers 95% of the nation’s elderly population, as well as many on disability benefits. In 1999, there were 39m Hospital Insurance claimants with benefit payments of $128.8 billion, and Supplementary Medical Insurance covered 37m enrolees with benefit payments of $80.7 billion.

Medicaid was created by the Social Security Act 1965 and is designed to provide medical assistance for individuals and families with low incomes and resources. The programme is jointly funded by the federal and state government, but is run by the individual states. Each state establishes its own eligibility standards, determines the type, amount, duration and scope of services, and administers its own programme.

Entitlement to Medicaid support is awarded if a family or individual is determined to be categorically or medically needy. However, Medicaid does not come close to covering all impoverished Americans, and over 44m Americans are completely without insurance. These are not necessarily the very poorest; rather, it is generally the ‘near poor’. There is effectively a healthcare poverty trap for those who earn too little to have healthcare benefits through their employer, but do not qualify for government health insurance on the basis of the means testing of Medicare and other welfare benefits.

Medicaid provides both in- and out-patient services on a fully funded basis, with a schedule of rates for treatments and drugs, and a nominal copayment. Each state Medicaid programme publishes its payment rates for different therapeutic treatments, and doctors or other healthcare providers choose whether to treat the patient on the basis of these rates. The doctor will either accept the Medicaid rate or tell the patient to go elsewhere.

Medicaid data reported by the states indicates that more than 41m people received healthcare services through the Medicaid programme in 1999. Total outlays for the Medicaid programme in 1999 include direct payment to providers of $133.8 billion, payments for various premiums of $31.2 billion, and payments to the disproportionate-share hospitals of $15.5 billion. Excluding administrative costs, the total expenditure for the nation’s Medicaid programme in 1999 was $180.9 billion ($102.5 billion in federal and $78.4 billion in state funds).

Most US hospitals are private, non-profit or profit-making institutions. There are some state and local hospitals, and a small number of federal government hospitals, most of which exist primarily for armed services veterans and are funded through the Department of Veterans Affairs. Individual hospitals may be affiliated with some university teaching and research centres. Hospitals are the main providers of specialist care in the USA, and often feature out-patient clinics along with their in-patient services. Generally, hospitals have their own internal pharmacy through which purchasing and distribution throughout the hospital are organised. The pharmacy can purchase directly from pharmaceuticals manufacturers and hospital suppliers, but often they join a larger buying group, such as an IDN. Some hospitals are affiliated to HMOs or other healthcare organisations that arrange purchasing for them.

Most hospitals are part of large groups that compete to supply healthcare services for HMOs and other contractors. A small number are vertically integrated into an HMO, such as the hospitals in the Kaiser organisation.

Group purchasing organisations (GPOs) are companies that purchase pharmaceuticals and other medical supplies on behalf of their clients (member hospitals and health systems). By aggregating many hospitals’ demand, these organisations are able to negotiate lower prices and more consistent supply than are usually available to individual hospitals. However, despite managing a significant share of hospital pharmaceutical purchases, GPOs have no control over the clinical drug utilisation within hospitals. This means that they are often unable to deliver the volumes guaranteed to manufacturers in order to achieve very low prices.

As a result of the high administrative fees charged by GPOs, many hospitals have begun forming IDNs (see below). Suppliers have also complained about GPOs, arguing that they force suppliers’ profit margins down to unreasonable levels and prevent negotiations with individual members.

Since the early 1990s, a large portion of US hospitals have become members of larger healthcare systems called IDNs. As many of 90% of all US hospitals are now involved in such a system. Many IDNs negotiate purchasing agreements directly with manufacturers or suppliers on behalf of their member hospitals. In this way they, like some HMOs and PBMs, are using their buying power to purchase directly from pharmaceutical manufacturers and distributors.

A7.5.1 Manufacturers

Manufacturers of pharmaceuticals in the USA can be divided into two categories: those that focus on research and branded drugs, and those that produce generics. After purchasing active ingredients and production supplies, manufacturers sell pharmaceutical products to wholesalers at the average manufacturer price. However, manufacturers often make deals with health plans and PBMs, offering discount prices to these bulk purchasers in return for a place on the formulary.

Major pharmaceutical manufacturing in the USA appears to be a relatively competitive industry, more so than generic manufacturing in the USA. However, within many therapeutic categories, the market is highly concentrated.

In terms of profitability, manufacturers of pharmaceuticals in the USA have been the top-ranking industry for profits as a percent of revenue. In 1999, pharmaceutical manufacturers had a profit margin of 18.9% compared to a median of 5% for all Fortune 500 firms.

Increasingly manufacturers are outsourcing certain R&D activities such as pre-clinical and clinical trials. ‘Study mills’ and contract research organisations specialise in performing drug trials more quickly and cost-effectively than well-known university testing groups and pharmaceutical companies could do themselves.

In the USA, the wholesaler industry is a concentrated market dominated by five firms. Wholesalers act as distributors, buying pharmaceuticals from manufacturers at the average manufacturer price, which is equal to the wholesale acquisition cost, and then selling them on to pharmacies using a ‘cost-plus’ approach (plus a mark-up percentage) or a ‘list-less’ approach (average wholesale price less a discount percentage). During the last decade, wholesalers experienced declining gross margins—the difference between the wholesale acquisition cost they pay the manufacturer and the price they sell to pharmacies—declining net profits and declining operating expenses.

US pharmacies include independent pharmacies, traditional chain drug stores, and mass-merchandiser pharmacies. Pharmacies purchase drugs from wholesalers at the actual acquisition cost, or sometimes directly from manufacturers at the average manufacturer price.

From 1990 to 1998, there was a decline in the number of retail pharmacies (from 59,000 to 52,000), and a shift away from independently owned pharmacies (40% in 1998 compared to 54% in 1990). Mail-order and Internet pharmacies in the USA also make up a small part of the market. The retail pharmacy industry appears to be moderately competitive, although sales from the top five pharmacy chains account for nearly 80% of prescription sales for the top ten firms.

The US pharmacy represents the virtual interface of patient, physician and health plan. Upon arrival to the pharmacy, patients with insurance present a card or number to the pharmacist who is able to access a network listing the drug formulary for the patient. In this way, the physician’s prescription can be managed by the health plan with the cooperation of pharmacists. Pharmacists have taken an increasingly active role in drug therapy in the USA. In recent years, this has led to alliances between large retail pharmacy chains and managed health plans.

There is a complex web of contracts and arrangements that underpin healthcare provision in the USA. In outline, all purchasers of healthcare obtain the actual patient treatment from the private healthcare market, which covers everything from doctors’ surgeries to major hospitals and specialist clinics. The purchasers must therefore arrange contracts and/or prices with these providers, either directly or by delegating the operation to a third party. The level of contractual complexity has escalated significantly since the managed-care system has been in operation.

The operation of fee-for-service indemnity plans is relatively straightforward, with the insurer determining the healthcare facilities that the patient can attend, the treatments available under the plan, and the drugs that will be reimbursed. The care provider charges the insurer once the patient has been treated, and the insurer charges the patient for their copayment portion of the total bill. In this way there are only limited contractual arrangements between the insurer and the providers.

The price base for drugs in the USA is the AWP, which is an average of the list prices from manufacturers and wholesalers. This price is very similar to the NHS Drug Tariff and suffers from the same problem—it is largely discredited as an accurate measure of the cost of drugs. However, it is widely used as a reference point for setting prices.

The small number of Medicare drugs are purchased at AWP – x, where x is determined legislatively. In the process of setting this discount, manufacturers complained that the returns would be too small, and x has remained small. The actual setting of AWP is recognised to be somewhat arbitrary, and attempts are under way to move the level closer to the actual acquisition cost. As x cannot be altered, this is to be done through a reappraisal of AWP itself, possibly through a judicial investigation of the actual prices charged. AWP is set by a few agencies appointed by the government, which receive the price data from manufacturers and wholesalers.

The extension of Medicare to include out-patient prescriptions would present a significant purchasing problem for the Health Care Funding Administration (HCFA) (ignoring the funding issue already discussed). The primary option would be for HCFA to go into the market to negotiate. However, many firms already fear that the government would not negotiate, but, owing to its buying power, would instead set prices.

One option is to allow PBMs to become the government’s agents. They would compete for regional contracts to supply prescription drugs for Medicare contracts on a two- or three-year basis. This issue is not yet fully worked out, and one of the key points is how any tender mechanism would operate over time, and whether it would have the anticipated effect (eg, which firms would actually win the contracts).

There are 56 state Medicaid programmes, and they have introduced a mechanism to work around the lack of price transparency in the drug pricing system. Pharmacists are reimbursed at close to their acquisition price of the drug, and are also given a flat dispensing fee. The main problem has been determining the appropriate acquisition price that could be applied to all pharmacists.

In order to overcome the problem of rebates and other methods of distorting AWP, the Medicaid Rebate Law forces manufacturers and wholesalers to reveal to the HCFA the prices paid for different drugs. The data gained in this way is kept very confidential—even other departments are not allowed access to the information. However, it is used to determine whether Medicaid obtains the best price from manufacturers.

The Rebate Law does not guarantee Medicaid the best prices as there are exceptions to its coverage—particularly the Veterans Association, which is known for obtaining very keen pricing from manufacturers. There are also various methods of evading full-disclosure cheap prices, but the HCFA is satisfied that the law is largely effective.

From an economic standpoint, the Rebate Law is not necessarily a pro-competitive tool. It could be considered as a most-favoured-nation clause, which is prohibited under competition law owing to its anti-competitive effects. In particular the Rebate Law would be expected to reduce the level of discounts available to all players, as any discount could, in theory, be made available on a mandatory basis to Medicaid. However, an investigation by the Congressional Budget Office concluded that the overall level of discounts had not changed from before the Rebate Law, and only the very lowest discounts had disappeared.

The structure of the industry for HMOs and other managed-care organisations is as follows. The responsibility for organising delivery of pharmacy services is delegated to PBMs, or coordinated by an internal PBM function. Hospital and other in-patient services are organised by the HMO itself, contracting with healthcare groups. For instance, Promina Health Services in Atlanta is in partnership with two of the largest HMOs (Cigna and Blue Cross/Blue Shield) to provide hospital service in support of their mass retail health plans.

Before contracting with a PBM, HMOs generally determine the drug prices that they are willing to pay. Drugs are one of the major cost drivers within the health system, and so accurate forecasting and low prices are critical to the profitability of the whole organisation. HMOs often use a maximum allowable cost basic for determining the price they pay through PBMs to pharmacy chains for drugs, if they do not negotiate directly with manufacturers to establish individual drug prices. Maximum allowable cost varies between HMOs, and is based on AWP when there are sufficient manufacturers for prices to fall. The end-price paid by HMOs is determined by the manufacturer price net of any rebates negotiated by either the HMO itself or its PBM.

The definition of a reasonable price is often subject to negotiation between the HMO and PBM, but maximum allowable cost is normally in the region of AWP – 40% to AWP – 55%. This represents pharmacists’ acquisition costs plus 30–50%, and is between 50% and 70% of the branded price. Overall there is a fairly good margin for the pharmacist. There is an additional dispensing fee of $1.50–2.

The PBM will usually be chosen by the HMO on the basis of its ability to negotiate rebates from manufacturers, its administration costs, and the extent of its affiliations with pharmacies. The PBM may be affiliated with large independent chains, such as Rite-Aid or Walgreens. Such independent retail chains contract directly with manufacturers or large wholesalers, and arrange a schedule of retail prices which then forms the basis of the reimbursement price and copayment determined by the HMO, or by the HMO in conjunction with the PBM. Similarly, PBMs will negotiate with manufacturers for rebates on specific drugs, based upon the total expected sales volumes guaranteed by the PBM.

The volume delivered by a PBM may include the business of several HMOs as well as indemnity plan and welfare prescription businesses. PBMs are able to guarantee a certain volume by adding a particular drug to the formulary list of the HMOs with which it contracts. In addition PBMs have a significant role in educating doctors and other health professionals so that they follow best practice recommended by the HMO.

HMOs, or PBMs on behalf of HMOs and other clients, negotiate price contracts (rebates) with manufacturers: for branded products, this is a straight volume-based negotiation, whereas, for generics, there is a competitive bid. The PBM chooses the manufacturer offering the lowest price (or most generous rebate), given security-of-supply guarantees. However, the market is not as fluid as it might appear because most pharmacy chains and the largest wholesalers employ ‘meet-the-competition’ clauses for off-patent products. The contracts are structured such that the incumbent supplier has the opportunity to match any price offered by a rival, which, in theory, enables the purchaser to benefit from price competition while maintaining continuity of supply of the same generic product, which is important to patients.

The result of these contract forms is that there is a rush for market share once a product comes off patent, and incumbents are very difficult to dislodge, especially if all firms have similar cost bases. Being late into the market after patent expiration by as little as three weeks can result in gaining only a very small market share. Customers are also very concerned with continuity of supply, and are therefore unwilling to accept supply from manufacturers or distributors that can only guarantee a short period of product supply or on a short-term basis (ie, no ‘fly-by-night’ activity). As would be expected, it appears that the market quickly settles into an equilibrium at prices that appear higher than they might be under ‘true’ competition, and market shares remain fairly static once the initial period of entry has passed.

The price charged by manufacturers is heavily dependent on the degree of competition. When the first manufacture produces the generic drug, the price normally falls to about 70% of the branded. However, once there is more than one firm (often there are many, once the exclusive six months is up), the price falls to 20–30% of the branded level. For Captopril the price has fallen to 10% of the branded equivalent. This low price led to some manufacturers ceasing production.

Most HMOs organise provision of drugs to their patients through independent pharmacy chains, either negotiating contracts themselves or delegating this to a PBM. However, some HMOs, most notably Kaiser Permanente, are vertically integrated and own the pharmacy chain. For these operators, having negotiated a price with a manufacturer, they also contract for delivery from a wholesaler that is selected on the basis of price, service attributes and reliability. Selection is often carried out through a tender process.

The HMO passes the details of the contract it has negotiated with the manufacturer to its selected wholesaler. The wholesaler purchases the supply volume from the manufacturer at the manufacturer’s list price (not the HMO contract price), and supplies to the HMO pharmacists at the HMO contract price plus a mark-up. Wholesalers frequently carry out a reconciliation with the manufacturer in order to take account of the purchase price of products supplied to the particular HMO, which is significantly below the manufacturer’s list price.

An important feature is that the wholesalers’ margins are often very slim, sometimes in fact negative, which implies that the wholesaler effectively pays the HMO to handle its volume. A major source of income for the wholesalers, about 25% of profit, comes from exploiting cash flows. They take advantage of differential payment dates between the manufacturers and customers (HMOs, PBMs or pharmacists). That is, they are generally reimbursed by the contractor within seven days of submitting an invoice, but the manufacturers have 60–90-day credit terms. Therefore wholesalers have the (significant) funds for the intervening period. In addition wholesalers make around half their profit from rebates from the manufacturers (over and above the price negotiated by the buying organisation where appropriate), and the remaining 25% was percentage mark-up on products that the wholesaler supplied on behalf of a buying organisation at a fixed price.

For health plans, PBMs and independent retail chains that do not contract directly with manufacturers, wholesalers buy from manufacturers at the best price possible and then supply in competition with other wholesalers. Pharmacists charge health plans or PBMs for the prescriptions they have filled, and receive the reimbursement designated by the plan. In addition, any patients who do not have prescription healthcare coverage pay the full retail cost of the drugs they have been prescribed.

The alternative to using a PBM is for an HMO to negotiate rebates with manufacturers, and then contract directly with large retail chains, such as Rite-Aid and Walgreens, which cut out the wholesalers. These chains agree supply with the manufacturer, warehouse the products themselves, and then claim the HMO-agreed price (with rebate) against volumes dispensed for that particular health insurer. Their ability to do this depends on whether they are the appointed preferred retail outlet for the patients of that health plan.

Underlying the whole system is an extensive use of IT systems. In the first instance these are necessary for individual pharmacies to check patients’ entitlements under their health plan, and determine their level of copayment for any particular prescription. This is achieved by a link from the pharmacy to a data clearing house which takes the patient’s details, interrogates the database of the appropriate HMO (or PBM if this function has also been delegated by the HMO), and provides a response to the pharmacist. This can all take only a few seconds and is done while the patient is waiting.

However, the level of data collection goes much further, with every aspect of the healthcare system being linked into the database operated by the HMO. Hospitals, clinics and doctors record all aspects of patient care, especially their prescribing behaviour. The volumes of drugs supplied under the contract with the HMO where applicable are detailed, providing a cross-check against dispensing data.

Figure A7.3 below shows the contract and payment network in the US system. At the centre is the HMO, which may or may not sub-contract the operation of its health plan to a PBM. If it does not, the PBM function is internalised—hence the dotted line surrounding the HMO–PBM linkage. In addition, large retail chains, such as Rite-Aid and Walgreens, arrange their own pricing, supply and distribution from the manufacturer, whereas smaller chains and independent pharmacists buy from wholesalers. This is illustrated by the dotted line around the wholesaler function, indicating that this element of the chain is omitted for some retailers.

Figure A7.3: Contractural and payment network in the US health system



Source: OXERA.

Facing steadily rising costs, healthcare purchasers and payers in the USA are expected to be increasingly vigilant about containing costs. In the managed-care environment, in particular, cost-control measures are expected to have effects on the pharmaceutical market. Managed-care companies use a computer network linked to pharmacies that lists the drugs included on the formulary that are available to an enrolee. These formularies typically encourage generics rather than branded drugs, and managed-care health plans and PBMs use formulary placings as a means of obtaining greater discounts and rebates from manufacturers. According to a 1998 report by the Congressional Budget Office, hospitals and clinics pay 9% less than retail prices; managed-care health plans or HMOs pay 18% less than retail prices; and the federal facilities pay 40% less than retail prices. These figures do not account for any manufacturers’ rebates or other benefits.

These discount buyers exert downward pressure on generic prices. Although this does not seem to affect the retail prices of branded drugs directly, the presence of generic substitutes for a given branded drug leads to better discounts for managed-care companies, hospitals and other bulk buyers when they purchase branded drugs. For example, the best price discount for a branded drug was found to be 10–14 percentage points higher when a generic version was available for four or more manufacturers.