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Following the Money: Untangling U.S. Prescription Drug Financing

Following the Money: Untangling U.S. Prescription Drug Financing


Introduction and summary

Compared with peer nations, the United States has had the highest per capita prescription drug spending for more than a decade, reaching an average of $1,432 per American in 2021.1 In 2019, U.S. prescription drug spending was more than 36 percent higher than Germany, the Organization for Economic Cooperation and Development (OECD) nation with the next-highest spending, and more than double the OECD average.2 American prescription drug spending totaled $378 billion in 2021, accounting for nearly 9 percent of health care spending and more than 1.6 percent of the United States’ gross domestic product.3 With such high prices, it is no surprise 1 out of every 3 U.S. adults taking prescription drugs say that they’ve been unable to take their medication as prescribed due to cost, according to a 2023 poll from KFF.4

1 in 3

Approximate share of U.S. adults taking prescription drugs who cannot take their medication as prescribed due to cost

The Biden administration took action to alleviate some of the pressure consumers experience with prescription drug costs by passing the Inflation Reduction Act, and Medicare enrollees are already feeling relief through monthly cost-sharing caps on insulin as a result of the law.5 Starting in 2025, Medicare beneficiaries with Part D coverage will see their out-of-pocket costs limited to $2,000 annually, which is projected to save nearly 19 million enrollees an average of $400 each year.6 The law further safeguards Medicare against drug price increases that exceed inflation by imposing rebates on manufacturers who increase the price of their products faster than inflation. And the Inflation Reduction Act grants the federal government new authority to negotiate Medicare drug prices, which the Congressional Budget Office (CBO) projects will generate savings of more than $100 billion over 10 years.7

The Inflation Reduction Act grants the federal government new authority to negotiate Medicare drug prices, which the CBO projects will generate savings of more than $100 billion over 10 years.

While historic, these efforts by the Biden administration and Congress should be considered only an initial step toward a more holistic approach policymakers must take to address the high and rising prices of prescription drugs for all Americans. Future policy actions should intervene at all points of the supply and financing chain, including measures to build supply chain resilience, stop patent system abuse, increase pharmacy benefit manager (PBM) transparency, and build upon the cost containment power of the Inflation Reduction Act.

Such an approach, however, requires a careful understanding of the pharmaceutical supply and financing chain, which is complex and nonlinear. This report describes the supply chain of prescription drugs and the financial arrangements that exist between the stakeholders in the prescription drug payment system and highlights policy options to improve prescription drug affordability for all Americans.

Read more on Medicare drug price negotiation


Glossary

Manufacturer: A developer and maker of prescription drugs, with some producing brand-name drugs and others specializing in off-patent generic drugs8

Pharmacy benefit manager (PBM): A middleman entity that contracts with health insurance plans to develop and administer pharmacy benefits, including negotiating with drug manufacturers to develop the plan’s formulary, as well as negotiations with pharmacies to develop the plan’s pharmacy network9

Wholesaler: A distribution coordinator between manufacturers and pharmacies that specializes in inventory management and product shipment10

Formulary: A list of drugs covered under a health insurance plan11

Tier: A category of drugs within a formulary subject to a specific cost-sharing arrangement for plan enrollees; formularies typically have several tiers with different cost-sharing structures for each tier12

Out-of-pocket costs (OOP): Costs the patient must pay for their care under their plan, including deductibles, copays, and coinsurance13

Spread pricing: A compensation scheme under which a PBM reimburses a network pharmacy less than the plan pays to the PBM for a drug, and the PBM retains the difference as profit14

Average wholesale price (AWP): The average price paid by retail pharmacies when buying a drug from wholesalers15

Wholesale acquisition cost (WAC): The manufacturer’s list price for a drug or biologic, not including any discount offered to a wholesaler or other purchaser16

Drug producers and suppliers are highly concentrated

Despite the unique nature of prescription drugs—the regulation of the market surrounding them and limited price transparency—the prescription drug supply chain is relatively straightforward. Similar to most retail goods, four main actors are involved in manufacturing and distributing prescription medications to consumers: raw ingredient suppliers, manufacturers, wholesalers, and dispensing pharmacies.17

At the beginning of a prescription drug’s life cycle, a manufacturer sources the raw materials needed to create the drug.18 This includes the chemical compounds necessary to make the drug’s active ingredient, as well as its inactive ingredients such as binders, coatings, and colorants. After manufacturing, wholesalers purchase and distribute 92 percent of prescription drugs in bulk.19 Depending on the order size, wholesalers may receive a discount for the volume of a drug they purchase from a manufacturer. The wholesaler then marks up the price of the drugs they purchased before selling them to either a hospital or retail pharmacy, where the drugs are ultimately dispensed to patients. Pharmacies place regular and frequent orders to wholesalers to manage their stock based on actual and anticipated patient demand.20

Unlike other consumer goods, the suppliers of the raw materials used to manufacture prescription drugs are relatively few and highly concentrated geographically.21 For example, in 2021, India was the source of nearly half of all pharmaceutical ingredients used in U.S. prescription drugs.22 This level of concentration leaves the U.S. market particularly vulnerable to shortages, which have real and devastating effects on patients.23 As of October 5, 2023, there were 128 active drug shortages in America. Shortages in chemotherapy drugs alone are currently affecting more than 90 percent of cancer treatment centers in the United States. 24 Likewise, the wholesaler market is highly concentrated in the United States, with just three firms now accounting for 90 percent of the market.25

In 2021, India was the source of nearly half of all pharmaceutical ingredients used in U.S. prescription drugs. This level of concentration leaves the U.S. market particularly vulnerable to shortages, which have real and devastating effects on patients.

Pharmaceutical stakeholders are connected by a complex flow of money and agreements

Tracking the flow of money through the prescription drug market is far less simple than tracking how the drugs move. This is due in part to the variety of actors in the market and because money often flows in multiple directions between the same actors.

To start, patients with insurance pay a premium to their insurance plan and make out-of-pocket payments to a pharmacy to purchase a prescription drug. These out-of-pocket expenses are based partly on their insurer’s formulary, which defines copayments and coinsurance amounts for different drugs based on a tiering structure. Patients without insurance, as well as patients who find it more affordable to forgo using their insurance at the pharmacy counter, pay the pharmacy directly out of pocket, often with the assistance of discount or price comparison services such as GoodRx, ScriptSave WellRx, and AARP.26

Most insurers contract with a PBM to administer prescription drug benefits. PBMs specialize in negotiating with drug manufacturers to build the plan’s formulary and function as administrators of the plan’s drug benefits, including processing prescription claims and reimbursing pharmacies for prescriptions dispensed to patients. In some cases, large insurers own a PBM—for example, UnitedHealthcare and OptumRx—and sometimes, PBMs are owned by pharmacy companies, as is the case with CVS and CVS Caremark.27 PBMs receive compensation through multiple channels for these services.28 They receive administrative fees from insurers to contract with them and from manufacturers that enter direct into agreements with them. When contracted insurers pay a pharmacy for the cost of prescriptions at a PBM’s negotiated rate, the PBM may take a cut of that cost, reimbursing the pharmacy less than the insurer pays the PBM, through a practice called “spread pricing.”29 Finally, PBMs may take a portion of manufacturer rebates they negotiate before passing the remainder to the plan. As such, a PBM’s total compensation is an aggregate of contract rates with insurers and manufacturers, as well as money retained from pharmacy reimbursements and manufacturer rebates.


How are drug formularies built?

PBMs build their formularies by negotiating rebates with drug manufacturers.30 These rebates are typically a dollar amount that the manufacturer will reimburse the PBM for each dose of medication dispensed to patients in the health plan. In these negotiations, PBMs seek higher rebates, and manufacturers want their product placed on a lower tier of benefit plans, making it more likely that patients purchase them due to lower cost sharing. The PBM has greater negotiation power for a drug when the plan that the PBM represents has higher numbers of enrolled patients and when there are therapeutic equivalents or alternatives, such as drugs in the same class. PBMs use a formulary tiering structure with variable cost sharing to direct patients to different medications; for example, in employer-sponsored insurance with more than three tiers, copays for tier 1 drugs average $11, while tier 4 drugs average $116.31

PBMs can also build and administer an insurance plan’s pharmacy network.32 To do this, PBMs negotiate reimbursement contracts with pharmacies, leveraging the volume of an insurance plan’s enrollees for lower reimbursement amounts. Pharmacies agree to a PBM’s offer based on a drug’s average wholesale price and its dispensing fee in exchange for access to the potential patients enrolled in the plan.33 Independent pharmacies often enter PBM network contracts through pharmacy services administrative organizations, which negotiate with PBMs on behalf of their members.34

From here, pharmacies use a portion of the PBM reimbursements to purchase new drugs from their wholesalers. Wholesalers pay for their orders based on a drug’s wholesale acquisition cost (WAC), and, depending on the quantity, the manufacturer may offer a discount or rebate. Wholesalers typically mark up the WAC before selling to pharmacies. For generic drugs, this markup averages 10 percent to 15 percent.35 While the markups for brand drugs tend to be lower as a percentage and brand drugs make up only 10 percent of retail prescriptions, brand drugs’ high prices result in wholesalers retaining substantial funds.36

This web of relationships between pharmaceutical buyers and sellers is complex, resulting in multiple interconnected points at which portions of a patient’s out-of-pocket drug expense is captured by different entities. Each of these points represents an opportunity for policy intervention.

Manufacturers’ prices determine downstream costs

While patients ultimately pay for drugs through premiums and cost sharing, drug manufacturers set prices on the other side of the supply chain. Unlike other product markets, consumer price sensitivity is blunted in the prescription drug market as many patients are largely shielded from the direct cost of the medication through their insurance.37Consequently, manufacturers set prices at what insurers and their PBMs are willing to pay. In turn, downstream prices depend on the manufacturer’s price. For instance, wholesalers’ markups are typically a percentage of the WAC, meaning that when the WAC increases, so does the value of the markup.38 Similarly, when PBMs negotiate rebates, they are rewarded for the value of the rebates, not the ultimate cost of the drug to the plan. Inflated drug prices drive increased health insurer spending, which ultimately raises costs for consumers through higher cost sharing and premiums.39


Manufacture price hikes lead to higher premiums for patients

Consider a hypothetical drug listed by its manufacturer at $1,000 WAC. A wholesaler may add 1 percent ($10) to the price, selling it to a pharmacy for $1,010. The pharmacy then also marks up the drug and adds a dispensing fee, for a total of $1,200. When the drug is dispensed, the patient has a $50 copayment, and the pharmacy bills the PBM the remaining $1,150, which is paid with funds from the insurer. At the same time, the PBM negotiates a $500 rebate with the manufacturer and keeps 10 percent of the rebate ($50) as part of the PBM’s profit. The rebate reduces the insurer’s cost from $1,150 to $700. This reduced cost to the insurer affects patient premiums and any cost sharing patients owe the insurer at the point of sale.

If the manufacturer increases the price to $2,000, the wholesaler’s profit will increase from $10 to $20. The pharmacy’s price will also increase, which may affect the patient’s cost sharing at the point of sale and increases the PBM’s cost. However, because the money the PBM uses to reimburse the pharmacy comes from the insurance plan, its profit, calculated based on the size of the rebate, remains unchanged, although the PBM may attempt to renegotiate a larger rebate. The manufacturer can offer up to $999 in rebates in addition to the original $500 and still make more with its rise in price, barring increases in production costs. To make up the difference, the plan will pay more through the PBM, which will drive premiums up for patients.

These misaligned incentives throughout the drug pricing system sustain high prices ultimately borne by patients. Patients absorb these high prices through cost sharing or directly out of their pockets if they have not met their deductibles or are uninsured. These unnecessary price increases also burden patients through higher health plan premiums.

Policy recommendations

Reforms throughout the pharmaceutical system are needed to lower consumer drug prices. While prescription drug financing relationships are complex, there are also abundant opportunities to address high prescription drug prices throughout the prescription drug system. The Inflation Reduction Act brought much-needed reforms at different points in the system for Medicare, including introducing cost-sharing caps on insulin, instituting rebates for price hikes above inflation, limiting annual out-of-pocket drug spending, and allowing the federal government to negotiate prices for the most expensive and commonly used drugs, benefiting millions of American older adults and disabled beneficiaries. Congress should expand upon these reforms to help even more Americans by lowering prescription drug prices at every step of the production-to-dispensation pipeline. For example, Congress might consider setting laws that intervene at various points during the drug patent and approval system, instituting regulations on PBMs, engaging in value-based pricing, expanding the impact of the Inflation Reduction Act’s provisions to commercial insurance, and securing the drug supply chain. (Figure 2)

Stop patent abuse by pharmaceutical manufacturers

Manufacturers of brand-name drugs can set the price for their products at exorbitant rates thanks to the exclusivity protections they enjoy under the U.S. patent code and through the Food and Drug Administration (FDA) approval process.40 U.S. patents protect an inventor for 20 years after a patent is filed, and FDA approval grants five to 12 years of market exclusivity, depending on the type of medication.41 As a result, manufacturer prices for a drug in the United States can be two to four times what is charged in comparably wealthy countries.42

Exacerbating the issue, brand manufactures often abuse the U.S. patent system to extend the life of their patents. Among the many tactics used, “product hopping” is a scheme in which a brand manufacturer will discontinue a product shortly before the end of the patent, shifting patients to a new alternative covered by a new patent.43 In 2014, Forest Laboratories, now Allergan, discontinued its immediate-release formulation of the Alzheimer’s drug Namenda IR and marketed an extended-release version of the same medication, Namenda XR. This decision prompted a lawsuit from then-New York Attorney General Eric Schneiderman, where he alleged antitrust violations for “product hopping.”44 Following the launch of the generic version of Namenda IR, the case was settled. Bills such as the bipartisan Affordable Prescriptions for Patients Act of 2023 (S. 150), introduced by Sen. John Cornyn (R-TX), would designate product hopping as an unfair trade practice, granting the Federal Trade Commission the ability to pursue antitrust enforcement actions.45

Other patent abuse tactics include: amassing “patent thickets” around a drug by patenting minor modifications to its form, dosage, or delivery mechanism;46 makingagreements with generic manufacturers to delay a generic drug coming to market;47 and using sham citizen petitions to abuse and delay the FDA generic approval process.48 These tactics make it significantly more difficult for generic competitors to enter the market to bring down prices and often result in higher revenue; in 2019, these practices added an estimated $40 billion to the cost of drugs.49 Such practices also incentivize manufacturers to modify existing drugs, rather than invest in innovative, new drugs.50 Congress has taken action to halt such abuses through revisions to the patent and FDA approval processes, including by proposing:

  • The bipartisan Ensuring Timely Access to Generics Act of 2023 (S. 1067), introduced by Sen. Jeanne Shaheen (D-NH)
  • The bipartisan Expanding Access to Low-Cost Generics Act of 2023 (S. 1114), introduced by Sen. Tina Smith (D-MN)
  • The bipartisan Increasing Transparency in Generic Drug Applications Act of 2023 (S. 775), introduced by Sen. Maggie Hassan (D-NH)

Congress has also proposed legislation that would explicitly enumerate the authority of antitrust enforcement agencies to police bad behavior, including in:

  • The Preserve Access to Affordable Generics and Biosimilars Act of 2023 (S. 142)
  • The Stop STALLING Act of 2023 (S. 148)

Both bills are bipartisan and were introduced by Sen. Amy Klobuchar (D-MN). The bills would allow generic manufacturers easier access to the market, bringing lower-cost alternatives and savings to patients, and would incentivize innovative drug research.51

Tighten regulation of pharmacy benefit managers

Another critical market area in need of oversight is the PBM landscape. Among other proposals, the bipartisan Pharmacy Benefit Manager Reform Act of 2023 (S. 1339), a bipartisan bill introduced by Sen. Bernie Sanders (I-VT) and advanced by the Senate Committee on Health, Education, Labor and Pensions (HELP), provides a road map for how to conduct this oversight.52 For example, rebate agreements between manufacturers and PBMs are often confidential, making PBM activity a black box.53 The Pharmacy Benefit Manager Reform Act of 2023 would require PBMs to submit reports of their activities to the plan sponsor, introducing much-needed transparency in claims processing and rebate negotiations. This would ensure that PBMs act in the best interests of the plans and patients they represent by allowing insurers and plan sponsors to fully understand what PBMs are paid and how much they cost the plan. Prohibiting spread pricing and requiring that 100 percent of rebates be passed through to the plan, an additional feature of this law, would further align these incentives by limiting PBM profit incentives to administrative fees paid by the plan. Policymakers should explore ways to ensure these rebates to the plan also translate to savings for patients.

Introduce value-based drug pricing

Drugs are priced based on what manufacturers believe the market will bear and are set to maximize manufacturers’ profits, often at the expense of patient access. An alternative approach is value-based pricing, which requires drug prices to be based on the benefit they provide to patients.54 Value-based drug pricing considers alternative therapies and whether new drugs present a safer or more effective option than what is currently on the market. That type of evaluation also balances the need to reward innovators for developing high-value products with financial accessibility to patients. In addition to bringing prices down to appropriate levels, value-based pricing would incentivize manufacturers to explore treatments for underinvested health conditions.55 Manufacturers have long resisted calls for policies designed to curb pricing—including value-based pricing—claiming that current prices are necessary for research and development funding.56 Yet one congressional report found that some of the largest manufacturers spend more on stock buybacks and dividends than on the research and development of new drugs.57 Further, some studies have estimated that 37 percent to 80 percent of “innovative” drugs that come to market have little to no additional clinical benefit over existing drugs.58

Expand Inflation Reduction Act drug negotiation and inflation rebate provisions

A close alternative to direct value-based pricing is direct price setting and negotiation on drugs with the highest spending. To that end, a key policy opportunity is to expand the scope of the Inflation Reduction Act’s maximum fair price negotiation and inflation-based rebates provisions to shield more Americans from price hikes on medications. Negotiated Medicare prices could serve as a basis for commercial insurers’ negotiations with manufacturers for some of the most expensive drugs on the market.59 However, proposals such as the Lowering Drug Costs for American Families Act of 2023 (H.R. 4895), introduced by Rep. Frank Pallone (D-NJ), would go further to expand those provisions formally—and would have a tremendous impact on out-of-pocket costs for more than 175 million commercially insured Americans.60 The CBO estimated that similar proposals before the previous Congress that would have extended drug price negotiation and prescription drug inflation rebates from Medicare to the commercial market would have generated federal savings of $492 billion over 10 years across Medicare and commercial markets.61 Beyond federal savings, expanding the Inflation Reduction Act to give private insurers access to Medicare-negotiated prices would ultimately lead to more affordable medications.

Learn more on drug price negotiation

Implement limits on out-of-pocket costs

While reducing drug prices is a more sustainable, long-term approach to bringing costs down, one of the fastest ways to provide relief directly to patients is through limiting their out-of-pocket costs for prescription drugs. The Inflation Reduction Act’s provision to limit Medicare beneficiaries’ out-of-pocket costs for insulin to $35 per month has already proved effective, with one recent study finding that thousands more older adults filled their insulin prescription following the copay cap.62 Since the passage of the Inflation Reduction Act, major insulin manufacturers have committed to $35 caps for their products for patients across all insurance markets.63 Proposals such as the bipartisan Affordable Insulin Now Act of 2023 (S. 954), introduced by Sen. Raphael Warnock (D-GA), would expand this protection to all Americans.64 Congress, as well as state governments, should build on this success and look beyond insulin to other high-value, high-cost drugs such as EpiPens and asthma inhalers.65 In addition to extending the cost-sharing caps on high value medications, Congress should also extend the maximum out-of-pocket expenditure protections of the Inflation Reduction Act to the commercial market as well as its out-of-pocket “smoothing” provisions to protect patients from massive pharmacy bills at the beginning of their plan year.66

Build greater resilience into the supply chain

In addition to addressing drug prices, Congress should secure the supply chain to protect the American people from shortages resulting from a concentrated supply market. To do this, Congress should expand the FDA’s authority to monitor the drug market by requiring greater manufacturer transparency.67 The Senate HELP Committee has already approved a reauthorization of the bipartisan Pandemic and All Hazards Preparedness and Response Act (S. 2333)which would grant the FDA this authority and allow the agency to get ahead of shortages.68 The HELP Committee’s bill would expand requirements for drug manufacturers to notify the FDA when they cannot meet the demand for a drug and provide the FDA with information on the supply of raw ingredients used to manufacture the drug. Congress should also consider policies to incentivize domestic manufacturing drugs and sourcing raw materials to protect the American drug supply further.69

Conclusion

The prescription drug supply chain consists of a complex web of relationships between manufacturers, insurers, PBMs, wholesalers, and pharmacies, all of whom are incentivized to capture profit at every step of the pharmaceutical manufacturing, distribution, and dispensing system. This results in higher prices for patients, whether through out-of-pocket costs or premiums. The Inflation Reduction Act was a groundbreaking step toward addressing high prescription drug prices and costs under Medicare and protects millions of American older adults and disabled people, including by introducing cost-sharing caps on insulin, instituting rebates for unwarranted price hikes, and requiring manufacturers to negotiate prices on the most expensive drugs. Now, it is up to Congress to craft a prescription drug reform package that addresses the industry as a whole, from manufacturing to the point of sale.

To address the root causes of high prescription drug prices, such a package should include patent and FDA reforms to bring lower-cost drug alternatives to market faster and revise how drugs are priced, either by expanding the Inflation Reduction Act to the commercial market or through value-based pricing. Instituting oversight and regulation of PBMs would address misaligned incentives between PBMs and the patients they serve. Finally, to address the immediate pressures on patients, any package should expand the pharmaceutical out-of-pocket protections of the Inflation Reduction Act to the commercial market. Policymakers must move forward with a comprehensive legislative approach to further bring down prescription drug costs and improve access to lifesaving medicines for all Americans.



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