Wednesday, November 18, 2009

Drug Prices and Pharmacy Profits

I’m sure most of you read Sunday’s New York Times article on drug prices: Drug Makers Raise Prices in Face of Health Care Reform.

The NYT story is based on the AARP’s latest analysis of prescription drug list prices: Rx Watchdog Report: Drug Prices Continue to Climb Despite Lack of Growth in General Inflation Rate.

Comparing list prices for a single product category to a computed, non-list price index for a broad basket of goods (CPI-U) is mathematically illogical. After all, the CPI-U for prescription drugs increased at a rate less than half the rate of list prices. But we all know appropriate comparisons don't get you on the front page of the New York Times.

Anyway, let’s assume the AARP computations are mathematically accurate and consider the following Drug Channels-related question:

Have pharmacy profits from brand drug prescriptions gone up, gone down, or stayed the same as average list prices have increased?

The answer may surprise you.


Pharmacies earn the majority of their gross profits on a prescription from “spread pricing”—the difference between (a) the “ingredient cost” reimbursement a pharmacy gets from a third-party payer or consumer minus (b) the pharmacy’s net acquisition cost for purchasing the product. Pharmacies also collect a fixed per prescription payment, a.k.a., a dispensing fee. See pages 16-20 of my pharmacy report for more details.

Most private and government third-party payers use the Average Wholesale Price (AWP) benchmark to estimate a pharmacy’s ingredient costs for a drug and compute a reimbursement amount. For instance, private employers in 2009 used an average discount of 16.4% from AWP, i.e., “AWP minus 16.4%,” as the ingredient cost reimbursement. AWP has a mathematical relationship to Wholesale Acquisition Cost (WAC), the list price used in the AARP study.


The AARP study shows the average WAC (and hence AWP) for a brand prescription increasing. So what happened to pharmacy profits as the reimbursement benchmark rose?

To find out, I translated the AARP computations into a crude monthly per-script AWP estimate. I’m keeping things simple by ignoring the AWP rollback issue.

The table below shows my computations for the average gross profit and gross margin per brand prescription. These are averages, so YMMV. Click the chart to enlarge it.

Two observations:
  • Pharmacies now receive a smaller percentage of a bigger number. The average AWP discount has increased. PMBI’s 2009-2010 Prescription Drug Benefit Cost and Plan Design Report, which survey employers (not PBMs) on benefit plan design, shows the average discount off AWP increasing from -14.1% in 2002 to -16.4% in 2009. Despite bigger AWP discounts, average pharmacy reimbursement per script has increased from $91 in 2002 to $144 in 2009—an annual average growth rate of 6.7%.

  • Gross profits per brand prescription have grown very slowly. A retail pharmacy’s acquisition cost for a brand-name drug can be reasonably approximated using AWP/WAC benchmarks due to the pricing structure for single-source brand-name drugs. hus, average gross profits per brand drug prescription have increased very slightly and average gross margins per brand prescription have declined. Note that these computations are sensitive to the particular assumptions for column [E].
  • Efficient, low-cost dispensing fulfillment is crucial to a pharmacy’s economic survival. You may be surprised to see average gross profits per prescription remaining fairly consistent over the 2002 to 2009 period. However, it does reconfirm my belief in the challenges facing a retail dispensing model. Wal-Mart agrees, as I note in Wal-Mart Explains Its Healthcare Strategy. These pressures are one reason the average daily number of prescriptions per pharmacy has been increasing steadily across all dispensing formats. See exhibit 8 of the pharmacy report.

  • Profits from generic drug prescriptions have saved the day for pharmacies. The retail generic dispensing rate has gone from about 40% in 2002 to about 70% in 2009. Generic prescriptions yield higher profits per prescription for pharmacies than brand-name prescriptions. This superior profitability is being threatened as healthcare payers implement new payment benchmarks and pharmacies engage in a generic prescription price war.

The AARP report was co-authored by Stephen W. Schondelmeyer, a professor at the University of Minnesota. He is quoted in the New York Times article as saying: “When we have major legislation anticipated, we see a run-up in price increases.

My web searching finds that tuition at the University of Minnesota increased by 7.3% this year (source) and by 7.5% last year (source).

Golly, those increases are quite a bit higher than the CPI-U, too.

I look forward to learning what major legislation is causing a run-up in tuition increases by the University of Minnesota.


  1. Wow. Great post Adam. Thanks for the clarity on the calculations. I learned a lot from this post.

  2. My tuition is going up as well, what the heck?

    Also, may I increase my price to my employer?

  3. From your last comment, I guess price increases above inflation only bother some people when their salaries are on the line!

  4. Sorry, I meant "when their salaries are NOT on the line"

  5. OK Adam, here's the lowdown on The U (Univ of Minn-Twin Cities), tuition, and their new approach to pricing.....grab some coffee, sit down and read up.

    About two years ago, Minn felt it was time to raise their "academic stature" in the Big Ten. Competing against Northwestern and Michigan (the two big guns), are Wisconsin and Illinois. Not that Minnesota is an average school, it's actually an awesome top tier "research" institution, but simply doesn't get the same level kids from across the country like Michigan does.

    Last year Minn changed their pricing philosophy. At the expense of the in-state residents, they LOWERED their out-of-state tuition rate to only slightly above the in-state rate. Their goal was to bring in kids from the two coasts and raise up Minnesota's level to recruit smarter kids (spelled higher ACT scores). It's not in their literature or on their website, but their pricing clearly reflects the new model (and the student tour guides share this same story). It has clearly been a revolt with the in-state families as New Yorkers and Californians take the spots that were originally meant for that Hibbing, MN young man.

    I think it's kind of like the WalMart pharmacy approach to pricing an education...well sort of. As long as WalMart can attract a higher level customer who will drop more dollars in the long run.

    Well, I've heard the Minn pricing program is actually working. Their admission stats have become more restrictive, and the mix of kids from out-of-state is growing.

    Yep, as a parent with 2 boys in college at the same time, I consider myself an expert in this field.

    And as a retail pharmacist in a high pressure, margin shrinking industry, you can be certain that I watch every penny and am continually looking for the best "therapeutic" outcomes for the lowest price possible.

    Oh salary has decreased every year for the past four years.

  6. Thanks for the clarification and detail.

    My real point is about the arbitrary and inconsistent nature of the AARP/Schondelmeyer conclusions. College costs are rising at 2-3X of the CPI, but I don't see any front-page stories in the NYT. Yet there is a reasonable analogy:

    1. People spend money on college because it delivers more value than it costs...just like pharmaceuticals.

    2. Many students (or their parents) don't pay "list price" tuition thanks to financial aid or loan forgiveness...just like pharmaceuticals. (In fact, the average person pays a much lower share of drug costs than college costs.)

    3. As you point out, there are many valid reasons for organizations (for-profit companies and non-profit universities) to adjust pricing...just like pharmaceuticals.

    Unfortunately, the AARP and Dr. Schondelmeyer seem more interested in getting their names in the newspaper rather than delivering an accurate assessment of the drug market. I have read some of Dr. Schondelmeyer's papers over the years and know that he is capable of more intellectually honest statements.


  7. Adam,

    You say that generic dispensing has saved the day for pharmacies, but do you have any proof of this? At my pharmacy, our gross profit from brand name drugs is pretty much right at your estimation. But generic reimbursement has plummeted in recent years. We now make much more money on the average brand name rx than on the average generic rx.

    We have:
    1. Only slightly increasing reimbursement on brand name rxs.
    2. Hugely increasing COGS on brand name rxs, which makes things very challenging when it comes to cash flow.
    3. Increasing costs of dispenging - which are increasing at a higher rate than brand name reimbursement is increasing.
    4. Rapidly shrinking gross profits on generic rxs (of course, this doesn't include mosst non-third party rxs).
    5. An ever-increasing % of generic prescriptions (most of which hardly even cover our cost of dispensing).

  8. Huh, interesting discussion about whole sale pricing and its relationship to gross margin per name brand prescription. Wasn't the article actually about drug manufacturer positioning / fixing of prices in the face of possible healthcare reform? Bait and switch?