Pharmacy Profits & Part D

The OIG released a new study last week on Part D economics for independent pharmacies. The report does a reasonably thorough job of examining actual, audited data on prescriptions filled by independent pharmacies under Part D.

However, the conflicting interpretations of this report illustrate why it’s so hard to understand the reality facing independents. The report is also a good opportunity for me to analyze the unfortunate economic realities facing the owners of lower volume, less efficient independent pharmacies. In my opinion, owners of low-volume independent pharmacies must either Get big, Get lean, or Get out.

As always, I encourage you to read the full report and make up your own mind: Review of the Relationship between Medicare Part D Payments to Local, Community Pharmacies and the Pharmacies’ Drug Acquisition Costs

IS THERE A GLASS?

Don’t be alarmed if you can’t figure out if the new OIG report is good or bad for independent pharmacies.

The Association of Community Pharmacists said that the new report “validates their concerns that payments under the Medicare drug benefit are driving some of them out of business” in Pharmacists decry Medicare drug payments. In contrast, PCMA sees the glass as half full, arguing that the report runs counter to claims from the independent drugstore lobby.

Steve Anderson of NACDS issued a cautious official statement with the intriguing double negative phrase that “pharmacies are not overcompensated.” His wording reminds me of the time my daughter told me that my new shirt “didn’t look totally uncool, for a dad.” (Gee, thanks.)

WHAT THE REPORT ACTUALLY SAYS

The OIG studied actual data for a sample of independent pharmacies to measure two components of Gross Profit per Script under Part D:

• Spread: The difference between (a) the “ingredient cost” reimbursements received by a pharmacy from a Part D Prescription Drug Plan (PDP), minus (b) the pharmacy’s net cost for purchasing the product (including rebates).


• Dispensing fee: The fixed per prescription payment.

Note that OIG expresses the spread as a percent of costs, not as a percent of revenues. Thus, we need to do some math to convert these data into more familiar Gross Margins, which express Gross Profit per Script as a percent of Revenue per Script.

Here are the averages that I calculated from the OIG report:

Brand-name drugs
Part D Revenue per Script = $127.49
Part D Gross Profit per Script = $11.29
Part D Gross Margin per Script = 8.9%

Generic Drugs
Part D Revenue per Script = $23.92
Part D Gross Profit per Script = $11.48
Part D Gross Margin per Script = 48.0%

I suspect that gross margins for the major chains -- CVS Caremark (CVS), Walgreens (WAG), and Rite-Aid (RAD) -- were similar to these figures. Note that generic and brand name scripts had roughly equivalent dollars per script even though gross margins differ by 39 percentage points.

YES, THE AVERAGE INDEPENDENT PHARMACY MADE MONEY WITH PART D

In the comments of Pharmacy Profits & PBM Contracts, I was accused of being misleading because I didn’t consider the cost of dispensing when discussing average revenue per script.

But I’m not a financial fool. I understand that gross profit is nothing more than PBE -- Profits before Expenses. Which brings us to the multi-million dollar question: Does the Part D Gross Profit per Script cover a pharmacy's fully-loaded per script operating expenses (a.k.a. the Cost of Dispensing)?

The OIG cites the National Study to Determine the Cost of Dispensing (COD) Prescriptions in Community Retail Pharmacies, which spawned the oft-repeated $10.50 average dispensing cost per prescription for 2006. Using the OIG data above (also 2006), the average COD leads to the following Return on Sales (Pretax Profit / Revenue) per Script:

Brand-name Drugs = 0.6%
Generic Drugs = 4.1%

While not spectacular, these figures suggest that the average pharmacy did make money at Part D. In addition, ROS only tells part of the profitability story because it ignores the balance sheet assets required to generate the income statement profit. Any wholesale or retail company should measure its true profitability using Return on Investment (Pretax Profit / Owner’s Equity). But I’ll leave it up to you to understand that ROS is only one of the three critical ratios in the Strategic Profit Model.

BUT SIZE MATTERS

However, Table 5 of the full COD study tells a different story when it reports COD for size-based quartiles. You will not be surprised to learn that these size-based differences have been conveniently ignored since publication of the report in January 2007.

Grant Thorton ranked the 23,152 pharmacies in the COD study by volume (number of prescriptions filled) and then grouped them into quartiles based on total prescriptions. Thus, the bottom quartile represented 25% of scripts and 46% of independent pharmacies. The top quartile also represented 25% of scripts but only 11% of independent pharmacies. In other words, the top quartile pharmacies were (by definition) larger.

Grant Thorton found a strong correlation between size and efficiency.

• The bottom size quartile (46% of independents) had average COD of $14.84, implying negative ROS for both brand and generic drugs in Part D.


• The top quartile had average COD of $9.01, implying ROS of 1.8% for brand-name drugs and 10.3% for generic drugs.

In other words, almost half of all independent pharmacies lost money with Part D prescriptions according to the data in the NCPA/NACDS Cost of Dispensing study. Yet the more efficient pharmacies made very respectable profits under Part D.

I can certainly sympathize with NCPA’s awkward position when confronted with these data because the 10,650 smaller, less efficient pharmacies (46% * 23,152) vastly outnumber the 2,547 larger, more efficient pharmacies (11% * 23,152).

MORE CONSOLIDATION TO COME

The Part D profit data hark back to my efficiency question posed last July in Heretical Questions about the AMP War: Does the U.S. retail pharmacy industry simply have too much capacity?

Now before you send me hate mail, I want you to recognize that I am just a messenger who is highlighting the evolutionary dynamics for you. You may not like the data that I present here, but these are the unpleasant facts.

OK, independent pharmacy owners – what do you think?

Part D and Generics

I wonder if branded drug makers are having second thought about the Medicare Part D benefit.

On one hand, Part D has demonstrably improved access and reduced out-of-pocket costs for seniors with no drug coverage. (See PhRMA’s September 2007 study.) Part D has also slowed drug diversion from Canada, which improves patient safety.

However, the much-maligned “donut hole” also appears to be encouraging greater generic substitution. Check out a new OIG report called Generic Drug Utilization In The Medicare Part D Program., which examines 341 million prescriptions paid by Part D in the first half of 2006. During the first six months of the Part D program:

• Generic drugs were dispensed 88 percent of the time when generic substitutes were available


• 56 percent of all drugs dispensed were generics

Hey, whadda ya know? People respond to incentives. Under Part D, seniors have strong incentives to keep their total drug costs below the lower end of the donut hole ($2,250). As a result, more seniors are trying to get the biggest bang for their buck by accepting generic substitution as well as shopping around at pharmacies.

Ironically, the donut hole may ultimately end up hurting brand manufacturers by accelerating already-rapid generic substitution rates. (Good New York Times article on this topic: Strategies to Avoid Medicare’s Big Hole). According to the Times, CMS estimates that generic dispensing rates are now 61.5%.

This unexpected dynamic could slow momentum for dramatic changes to the Part D program. Democrats perpetually chatter about using “direct price negotiations” with manufacturers to fund the elimination of the donut hole. Although the structure of the Part D benefit makes such negotiations virtually impossible to implement, brand manufacturers will likely feel much more pricing pressure from Part D plans.

The next few years will see an enormous wave of new generics. In 2006, Part D cost the Federal Government $47 billion in 2006, which is $13 billion less than the original estimate of $59 billion. Generic drug substitutions were a prime contributor to the 2006 reduction and lowered future cost estimates. Look for further reductions in the estimated cost of Part D, especially if Average Manufacturer Price (AMP) gets linked to Part D.

Ironically, I learned over Thanksgiving that my own grandmother was one of the few seniors who hit the donut hole. Why? Grandma told me that “she doesn’t believe in generics” because “they are just not as potent.” (I'm not making this up!) She insists on paying for brands even though her own pharmacist said that she is wasting her money.

Don’t worry – I thanked her on behalf of all branded manufacturers.

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BONUS: Boomer humor

Click here to see a very funny animation aimed at readers who are (or will soon be) eligible for Part D!

Part D + AMP = Trouble

The Democrat-controlled Committee on Oversight and Government Reform kicked off another round of predictable complaints about Medicare Part D with their report on private Medicare drug plans. Even Ed Silverman at Pharmalot felt the need to join the industry-bashing with his pejorative headline Medicare Part D Is A Costly Mess.

Although it’s a little early for Halloween, I want to give you some scary nightmares about a new monster that could walk among us very soon.

As I see it, the Part D debate and the Average Manufacturer Price (AMP) debate will soon converge. This potent combination would disrupt the retail pharmacy and drug wholesale industry while simultaneously crippling the innovative capacity of the pharmaceutical industry.

AWP Lives!

Page 14 of the new report on private Medicare drug plans provides some interesting data about pharmacy economics under Part D. The 12 Prescription Drug Plans (PDPs) in the Committee’s report reimburse pharmacies using the following formulas and payments:

• Discount off AWP: 13.5% to 16.5%


• Dispensing fees: $1.70 to $4.00

The Committee found that the average pharmacy payment from Part D insurers = AWP-15% + $2.10. Thus, a pharmacy would receive a payment (reimbursement) from the PDP of $87.10 for filling a Part D script with an AWP of $100.

NCPA keeps complaining about "low and slow" payments under Part D. I discussed the "slow" myth last month. Seems like they should turn down the rhetoric on "low" payments, too. What do pharmacists want -- AWP + 250%??

As an aside, the report incorrectly states that this amount represents a cost to the Medicare beneficiary. In fact, only beneficiaries in the “donut hole” would pay this amount as an out-of-pocket cost, assuming they had no additional coverage. According to IMS’ Part D report, just 6% of beneficiaries fell into this category. That’s not “typical” (common, average) based on my definition, although the headline to Figure 7 claims to show the “Flow of Payments for a Typical Brand Name Drug.” Whatever.

The Part DAMP Monster

Let’s review a few themes from the past few months of Drug Channels:

• The AWP system is wounded and can not be repaired. (Sorry to be the bearer of bad news…) The new Part D report trashes AWP in Section D.
  
• CMS and the states currently pay for 40 percent of U.S. retail prescription drugs through Medicaid, SCHIP, and Medicare. It'll be 50% within 10 years.
  
• CMS is launching a new pricing benchmark called Average Manufacturer Price (AMP).


• CMS is encouraging states to adopt AMP-based reimbursement methodologies for pharmacies.


• AMP is widely opposed by everyone in the industry. Therefore, anti-pharma advocates will assume that AMP has merit.
• The Democrats have been critical of the Part D benefit design, despite its popularity. (Hey, I warned you to watch out in July 2006!)

Now add politics into the mix. If the Democrats take back the White House, then we will have a new CMS Administrator in 2009. We may also have a Democrat-controlled Congress, too.

What if CMS requires Part D PDPs to adopt AMP-based methodologies for pharmacy reimbursement? Or mandates the use of AMP-based Federal Upper Limits (FUL) for both brands and generics in Part D?

The possibilities for mischief are virtually unlimited.

Spooky.

Time for Jeff Kindler to rethink his campaign contribution strategy?

Hype vs. Research

On Tuesday, I posted A Misleading Study on Pharmacy Reimbursement, a critique of a new study describing pharmacy reimbursements under the Medicare Part D program. The full research paper from the Journal of the American Pharmacists Association can now be downloaded here: Prescription drug payment times by Medicare Part D plans.

The complete article naturally offers a much more nuanced perspective than either the Executive Summary or NCPA’s press release. However, the authors and NCPA overreach by drawing conclusions that are not supported by the study. Their attempts to shift blame to payers, customers, and wholesalers are designed to influence health care policy in a way that benefits pharmacies at the expense of everyone else.

Thus, my primary critique remains valid – the results of this study are being marketed in a misleading way to the public and to Congress. The evidence in this study certainly does not warrant having Congress interfere in the working of a competitive free market.

What the Study Really Says

The actual paper is well-reasoned and carefully worded. The researchers – Dr. Shepard, Dr. Richards, and Ms. Winegar –present detailed statistical summaries information broken out by month, by year, and by Part D plan.

One hidden bias comes in the aggregation of time frames for analysis. The authors show us only four points in the distribution: less than 15 days; 15-30 days; 31-60 days; 60 days or more. Thus, a claim paid on day 32 is treated the same for the purposes of their analyses as a claim paid on day 60. The impact of this choice is not readily apparent, but would be quite significant for concluding anything about the cash flow impact on a pharmacy.

As I correctly deduced from the Executive Summary, the median number of days to payment after adjudication dropped below 30 days for the last five months of 2006. Amazingly, one of the headline conclusions of the summary – “50.0% of claims were paid more than 30 days after adjudication” – is actually false for the last five months of 2006! (See Table 1 in the paper.)

The academic tone stands in sharp contrast to the summary and NCPA press release that I wrote about on Tuesday. The Executive Summary is attributed to the same researchers and presented on the letterhead of the Center for Pharmacoeconomic Studies. My critique of the summary remains valid, especially with regard to changes over time throughout 2006.

Strategy #1: Blame Payers

NCPA desperately wants to conclude that PBMs and third-party payers are guilty of “destroying” independent pharmacies. NCPA even goes so far as to make the following claim: “This study presents strong evidence that PBMs are ‘gaming the system’, making interest on the ‘float’ they get by not paying pharmacies in a timely manner.”

The actual research paper provides no support (strong or otherwise) for such a conclusion. NCPA appears unwilling to consider possible alternative explanations for declining numbers of independent pharmacies. As I noted on Tuesday, the amount of financial hardship facing an average independent pharmacy may not be enough to tip a healthy, well-run business into bankruptcy. It’s a stretch to blame payers based on the paper.

Strategy #2: Blame the Customer

What if the decline of independent pharmacy is really part of a larger shift in consumer preferences? Many U.S. consumers prefer to shop at larger stores. As a result, retailing is become more concentrated and increasingly dominated by chain stores, warehouse clubs, home centers, and big box superstores. (I discuss these issues in more depth in Chapter 8 of my new book Facing the Forces of Change®: Lead the Way in the Supply Chain.)

As the table below shows, pharmacy is on par with other retail sectors dominated by large chains, at least judging by the decline in the number of small companies (less than 20 employees. (Source: Statistics of U.S. Businesses.)

Note that the most recent data are from 2004, well before Part D.

Here’s an even more controversial explanation—maybe independents are upset at losing cash pay customers who now have access to a comprehensive drug benefit. As pharmacist Tom Connelly pointed out in his comment on Tuesday’s post: “Our biggest problem with Medicare Part D was seeing a minor, but not insignificant, portion of our prescription revenue going from immediate pay--cash on the barrel head--to 30 to 40 days out.”

Would pharmacists really prefer that seniors reach into to their own pocket simply to alleviate their cash flow problem? (No, of course not.)

Strategy #3: Blame the Wholesaler

It also defies economic logic to point the finger at the wholesalers for their payment terms. Smaller retail customers rely on wholesalers for many services—delivery, credit, generic sourcing, retail management. As a result, an independent pharmacy provides higher profits for a wholesaler than a large, powerful, self-distributing pharmacy chain such as CVS Corp or Walgreen (WAG).

Why would wholesalers want to kill their most profitable customers? In reality, wholesalers are working hard to help independent pharmacies survive in an increasingly competitive industry. (See Trouble Ahead for Independent Pharmacies for more background.)

Making Policy

Based on an objective look at the available evidence, there seems to be little compelling reason for Congress to interfere in a free market that will ultimately arrive at a reasonable solution for all parties. The marketplace reality is that third-party has overtaken cash pay at the pharmacy. We can’t rewind the world to make it more convenient for operators of independent pharmacies.

Perhaps I am too skeptical, but I wonder how many policymakers will venture beyond the Executive Summary and NCPA’s press release on this issue. The high level talking points are likely to crowd out an appropriate discussion of the costs and benefits to consumers and our health care system. Hopefully, my blog posts can make a small contribution to a more fact-based debate.

A Misleading Study on Pharmacy Reimbursement

NCPA is touting the results of a new study that purports to provide “incontrovertible evidence of the slow reimbursement pharmacies have endured with Medicare Part D prescription drug claims.” (See the press release.) NCPA is quite forthright in their desire to influence two bills pending before Congress: S.1954 (Pharmacy Access Improvement Act of 2007) and H.R.1474 (The Fair and Speedy Treatment of Medicare Prescription Drug Claims Act of 2007).

I strongly disapprove of the manner in which this study’s results are being presented to the public and to Congress. It would be foolish to base health care policy based on the partially-disclosed results of this incomplete and biased study.

Bikini Research

The full study has not been released so we can only rely on the skimpy Executive Summary. And like a skimpy bikini, what the summary reveals is interesting -- but what it conceals is essential.

Consider this example of selective disclosure.

As we all remember, the Part D launch in January 2006 was fraught with operational difficulties, many of which were subsequently resolved. According to IMS Health, Part D scripts grew from 0% to 17% of the retail market during the first six months of 2006 before stabilizing at 17% for the second half of 2006.

Yet the Executive Summary conveniently averages all of 2006 together, thereby artificially inflating the magnitude of the "prompt payment problem."

Here are the implied median number of days between submission and adjudication as reported in the summary:

January 2006: 106 days
February 2006: 93 days (-12% vs. January)
March/April 2006: 54 days (-49% vs. January)
May through December: No disclosure

The trend is clear, but where are the data from the rest of the year? If the Executive Summary was intellectually honest, then it would have provided more information about changes over time. At a minimum, the summary should show the results for the first half versus second half of 2006.

These omitted data are crucial for interpreting the overall 2006 results. Figure 1 implies that the annualized median is 30 days for independent pharmacies and much lower for chains. Thus, the trend shown for the first four months must have continued. The median may have even dropped below 30 days for certain months in 2006!

Real-World Impact?

I published some Heretical Questions about the AMP War last month. Let me ask another heretical question: Is the magnitude of the allegedly slow payment worthy of a legislative fix?

The average independent pharmacy in this study filled 4,138 Part D scripts in 2006. The average retail script generated $60 in revenue at an independent pharmacy in 2006 (Source: NACDS). Therefore, Part D represented about $250,000 in annual revenue (about $21,000 per month) for a typical independent pharmacy in 2006. If half of these reimbursements come after 30 days, then the pharmacy is floating an additional $10,500 for a few weeks throughout the year.

Is this estimated float amount financially significant enough to require an Act of Congress? The study is silent on this matter, as well as other relevant questions. Are Part D claims being paid faster or slower than the other 90% of scripts? How are Days of Sales Outstanding (DSO) changing? What else should pharmacies be doing to better manage their balance sheet? What explains the performance gap between independents and chains? How sensitive are the results to the choice of break points (15 days, 30 days, etc.)?

The Full Story, Please

In my opinion, NCPA and the researchers will ultimately damage their credibility by peddling these partial results, which do nothing more than reinforce NCPA's longstanding preconceptions about PBMs. In the meantime, I call on the researchers and the NCPA to immediately release the raw data underlying the Executive Summary so that it can be subject to independent analysis and scrutiny.

I’d love to hear from you about this post. Email me or post a comment (anonymously, if you choose).

2007 Trends: Democrats Take Over (4 of 4)

Here is the fourth of four posts about major health care trends that I am watching for 2007 along with links to my posts from last year. The first three trends are:

• Trend 1: Pharmacy Infrastructure Integration
• Trend 2: Lobbying for Retail Pharmacy Profits
• Trend3: DIY Supply Chain Security

Trend 4: Democrats take over

Democrats have health care on their mind, especially with the 2008 Presidential election starting to heat up. The Washington Post had a good overview last week. See Shift in Congress Puts Health Care Back on the Table.

I view direct negotiations for Medicare as a long shot for Speaker Pelosi’s first 100 hours. (The draft text of H.R.4 The Medicare Prescription Drug Price Negotiation Act of 2007 looks like meaningless window-dressing with limited impact on the marketplace anyhow.) However, Congress seems likely to focus on how companies within the U.S. pharmacy infrastructure make money, putting PBMs and wholesalers under greater scrutiny. I would not be surprised to see new Congressional hearings about contracts, rebates, and chargebacks.

The proposed AWP settlement, along with the ongoing litigation around this pricing benchmark, will create further heat. The Wall Street Journal is also adding fuel to the fire with its muckraking against the pharmacy infrastructure with year-end articles on taming middlemen and Omnicare Inc. The theoretical saving from universal health care will also focus attention on the pharmacy infrastructure -- just listen to John Edward's weekend remarks or read Sunday's article in (where else) The New York Times.

• The Part D direct negotiations movement
• Additional Comments on the AWP settlement
• AWP Ain’t What Matters
• Are the Democrats helping Wal-Mart's Pharmacy

New York Times editors read this blog!

I don't normally agree with the New York Times editorial page, but it looks like they agree with me.

On Monday morning, I posted CMS as a PDP: A Part D compromise? suggesting a compromise on Part D that could avoid a Presidential veto:

"Medicare beneficiaries will have the option, but not the obligation, to enroll in a national plan based on directly negotiated prices. The current system of regional PDPs will remain, in effect putting the government into competition with private plans."

On Tuesday morning, The New York Times ran an editorial called Lowering Medicare Drug Prices, which states:

"The approach that most appeals to us would direct the secretary of health and human services to set up one or more government-operated drug plans to compete with the private plans. "

Interesting coincidence, don't you think?

CMS as a PDP: A Part D compromise?

Today's Wall Street Journal has a great editorial by Alain Enthoven and Kyna Fong on the Democrats' plan to push for direct negotiations between Medicare and the drug companies. See Pelosi on Drugs.

Despite these logical arguments, “Direct negotiations” has a simple, populist appeal that is hard to ignore. Just consider the fact that the issue was only narrowly defeated in a Republican-controlled House and Senate. (See my July post The Part D direct negotiations movement for background.)

I predict that a new compromise will emerge to avoid the prospect of a Presidential veto. Here's a brief sketch of how it might work:

• Medicare beneficiaries will have the option, but not the obligation, to enroll in a national plan based on directly negotiated prices.
• The current system of regional PDPs will remain, in effect putting the government into competition with private plans.
• The government plan will receive an additional rebate analogous to the Medicaid rebate program, which seeks to ensure that Medicaid agencies pay the lowest (“best”) price available to any other customer.

If enough seniors believe that lower drug prices are the only key to lower premiums, then the government will capture more beneficiaries. However, seniors may be rightly skeptical of the government’s one-size-fits-all plan and presumably lower service levels, allowing the PDPs to survive and choice to remain.

Happy Jack

Part D has proven to be a very popular program, judging by the many polls on the topic. According to the latest poll from the Wall Street Journal and Harris Interactive:

• Three-quarters of enrollees say they are satisfied with the plan, compared with 24% who aren't satisfied.
• 70% say the plan has saved them money on prescription drugs, compared with 20% who say it hasn't.
• The plan has been easy to use, say 82% of respondents vs. 13% who disagree.

PhRMA also released its own study (available here) showing a steep (74 percent) drop in average patient out-of-pocket costs.

The Seeker

Yet the direct negotiations crowd ignores the risk that changing the structure will lower satisfaction by reducing choices. I worry that the Democrat’s emotional focus on squeezing a few theoretical pennies out of drug makers may blind them to this variety.

A big benefit of today’s structure is the choice created with the competitive system. I looked up the plans in my home zip code in Pennsylvania using CMS’ online Prescription Drug Plan Finder. I found 66 prescription plans for 2007 with monthly premiums ranging from $14.80 to $104.50 (average premium = $36). There is substantial variation in deductibles, cost sharing, and coverage in the gap. A national view is available in this handy summary from the Kaiser Foundation.

The range among my local 66 plans indicates that seniors have a lot of choices and can select a plan based on personal needs and individual situation. I suspect many seniors would not be happy in a one-size-fits-all plan. And as I pointed two weeks ago, direct negotiations may also throw the pharmacy industry into chaos and help Wal-Mart – true irony for Democrats! (See Are the Democrats helping Wal-Mart's Pharmacy?

If Medicare offered its own PDP, then the actual beneficiaries could decide whether the government's (presumably) lower prices are better than one of the other 66 options available. Seems fair to me.

It’s Not Enough

I also want to comment on the embedded assumption of direct negotiations -- lower pharma prices are automatically beneficial to society in the long run. This assumption is not as self-evident as it might appear.

To quote from the Amazon description of Richard Epstein's new book Overdose: “While critics of pharmaceutical companies call for ever more stringent controls on virtually every aspect of drug development and approval, Epstein cautions that the effect of such an approach will be to stifle pharmaceutical innovation and slow the delivery of beneficial treatments to the patients who need them.” (I am currently reading this dense, challenging book and will post a review sometime after my next long flight.)

Or as Peter Pitts as Drugwonks puts it: "to paraphrase Winston Churchill) our pharmaceutical patent system is the worst way to stimulate and support health care innovation – except for every other system." (See There’s a prize in every box!)

I recently attended a conference at which the keynote speaker made an off-hand remark that “drug prices are too expensive.” But as an economist, I must ask: “Too expensive compared to what?” Getting sick? Dying?

By all means, let's have a vigorous debate about how to make tough tradeoffs in health care. But is it naïve to think that mandating “lower” prices will not have unintended and potentially undesirable consequences.

Lunch is still not free.

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P.S. Observant readers will recognize the subliminal plugs for my favorite new CD Endless Wire. Hope you buy before you get old!

Are the Democrats helping Wal-Mart's Pharmacy?

Halloween came a little early to the pharmaceutical industry today. The New York Times has an article called Confident Democrats Draft Broad Health Care Agenda. Check out this statement regarding the Medicare law’s prohibition on direction negotiations with drug makers: “Representative Nancy Pelosi of California, the House Democratic leader, said that if Democrats were in control, they would try to repeal that ban in the first 100 hours after the House convenes.” Boo!

The always-provocative Peter Pitts at the DrugWonks blog summarizes Pelosi’s plan very succinctly as The 100 Hour Reign of Terror. (Great title, Peter!)

Back in July, I warned about the risks facing pharmaceutical manufacturer and the drug channel (wholesalers, retailers, and PBMs) were the government allowed to negotiate directly with drug makers as part of Medicare. See The Part D direct negotiations movement. (Check out the “uncomfortable questions,” which have turned out to be good discussion-starters in planning sessions.)

Channel Impact

I’m not sure that direct negotiations could actually come to pass within the next 2 years given the prospect of a Presidential veto. But the post-2008 environment is certainly up for grabs, so let’s think through how direct negotiations would work.

A single-negotiator model would most likely lead to price-plus pharmacy reimbursement for Medicare Part D. In other words, reimbursement would be equal to the CMS’ negotiated “best price” or perhaps some variant of Average Manufacturer Price. PDPs would still be free to differentiate based on plan design and retail network breadth, maintaining elements of today’s market-driven plan approach.

This reimbursement model would cap the total revenue to be split among all channel players. In other words, price-plus reimbursement effectively caps the total compensation that can be earned by PDPs, retail pharmacy, wholesalers, PBMs, providers, and anyone else handling the product after it leaves the manufacturer’s factory.

Does Wal-Mart win?

The Part D winners in this scenario will be the low-cost channels providing a total dispensing and benefit management solution. For example, mail order fulfillment's relative efficiency versus retail dispensing helps PBMs sustain their value in the drug channel.

Ironically, the Democrat’s plan may also end up benefiting one of their current enemies -- Wal-Mart. Wal-Mart’s famed supply chain efficiency becomes a powerful weapon, especially if it is combined with a solid plan design. Imagine a Wal-Mart PDP, and all of sudden Wal-Mart’s recent attempts to build foot traffic in their pharmacy start to look much more strategic ... and certainly not the outcome that Nancy Pelosi expects.

The Part D direct negotiations movement

Last Thursday, House Democratic Leader Nancy Pelosi and other senior House Democrats asked for a floor vote on direct negotiations between the US government and drug manufacturers for Medicare Part D. (Read the press release here.) The Senate rejected similar amendments to the Medicare act last November by a 51-48 vote and in March 2005 by 50-49.

The Democrats are making Part D “reform” into a major theme of the 2006 elections. Our charter at Drug Channels includes examining the effects of policy on the pharmaceutical supply chain, so I’ll defer comment on the political angles.

Nevertheless, a direct negotiations scenario is certainly possible. This shift could have dramatic consequences for manufacturers in the areas of channel strategy, pricing, and trade account management. Wholesalers, retailers, and PBMs should also be paying close attention to the strategic business implications as the “cost of the channel” becomes more prominent and visible.

A Direct Negotiations Scenario
Let me sketch a few factors (beyond political posturing) that could favor a direct negotiations scenario:

• The government will be paying almost half of the entire US prescription drug budget within a few years via Medicaid and Medicare. Yikes!
• The tab for Part D, an unfunded expenditure from general revenues and premiums, is likely to force some uncomfortable trade-offs among non-entitlement budget spending. According to the 2006 Medicare Trustees Report, Part D costs are projected to increase at an average annual rate of 11.5 percent from 2006 to 2015.
• A steady drumbeat of research studies (Example One and Example Two) purport to show how much could be saved with direct negotiations. (No hate mail, please – these are examples, not endorsements.)
• A Democratic Congress and/or President Hilary Clinton

I assume that you agree that we can assign a non-zero probability to the direct negotiations scenario.

How much should we pay for the drug channel?
Currently, pharmacy reimbursement levels for Medicare Part D are determined by the marketplace through network contracting negotiations between pharmacies and Medicare PDPs, not set by CMS.

I believe that a direct negotiations scenario will migrate CMS Part D reimbursement to an “average price plus” model. In my post from early May, I noted that government reimbursement for pharmaceuticals is moving away from “discount off list” (AWP minus). Consider:

• Medicare Part B now reimburses outpatient drugs to providers at Average Sales Price (ASP) plus 6 percent.
• Starting in January, Medicaid’s reimbursement to retail pharmacy for generic drugs will be the to-be-defined Average Manufacturer Price (AMP) plus 250 percent. (See my June 8 post for more on AMP.)

Key point here: An “average price plus” model does not claim to measure actual pharmacy or provider acquisition costs for drugs. Instead, these models use actual manufacturer transaction prices plus a drug channel cost factor. Dr. McClellan voiced his support for these models in his comments to last summer’s OIG comparison of AMP to AWP and WAC. (See pages 24 to 26 of this OIG report.)

Some uncomfortable questions
It’s beyond the scope of my blog to write about all of the strategic implications here. (Hey, that’s my real job!) But here are a few questions to ponder:

1. A “price plus” approach effectively caps the total compensation that can be earned by wholesalers, retailers, providers, or anyone else handling the product after it leaves the manufacturer’s factory. Who will win if wholesalers and retailers begin competing for the fixed (and probably lower) channel margin?
2. Prescription pharmacy is 69% of CVS’ revenue and 66% of Walgreen’s revenue, making the government responsible for at least a third of top line at the biggest chains. Will this accelerate pharmacy consolidation, reduce margins, or both?
3. The next round of fee-for-service negotiations will be coming up in the next 18 months. How much will/should a manufacturer compensate the drug channel to perform activities that become uneconomic in a “price plus’ reimbursement model?
4. How will the relative attractiveness of alternate distribution models, such as third-party logistics providers, change once drug channel margins are subject to more scrutiny?

Direct negotiation is just a scenario – for now.

P.S. A few people wrote to ask me about the meaning of disambiguation, which I used in the title of my last post. For the record, disambiguation means “clarification that follows from the removal of ambiguity.” See? This blog really does make you more perspicacious!

One more thing on Walgreen's

Today’s WSJ has a fascinating article about Walgreen’s success with Part D called “Getting an ‘A’ in Part D.”

My dead canaries post speculated on merger possibilities between chains and PBMs. This article provides some further supporting evidence. The WSJ article states:

“Part D reimbursement rates -- which are set by insurance companies but reviewed by the government -- vary widely but are usually so low that many independent pharmacies worry they will be put out of business. . . .Some small pharmacies, unable to pay their employees, already have closed their doors. Others are refusing to honor insurance plans with the lowest reimbursement rates.”

In other words, independents and small chain have to (a) play ball at lower rates, (b) lose business by turning away customers, or (c) shut down.

However, the tables are turned for a chain with strong store loyalty and a high share of outlets in a given geographic market. Leveraging countervailing power against payers allows the channel to extract adequate compensation for access to customers, creating another advantage under Part D for larger players.

These battles can continue indefinitely, as happens in many U.S. distribution channels. Walgreen’s role as PBM for UnitedHealth’s plan illustrates the alternative approach of vertical consolidation between channel and payer. No mandatory mail order here!