Tuesday, March 14, 2017

Scott Gottlieb’s Radical Idea for Disrupting U.S. Drug Channels: Implications for PBMs, Wholesalers, and Pharmacies

President Trump has nominated Scott Gottlieb, M.D., to be the commissioner of the Food and Drug Administration (FDA). I’ve been a big fan of Dr. Gottlieb’s for some time, and think he is an outstanding choice.

In addition to his role overseeing the FDA, Dr. Gottlieb will be a key policy advisor to the Trump administration on drug pricing. As you will see below, Dr. Gottlieb is unusually familiar with the warped incentives in the gross-to-net bubble—the growing spread between a manufacturer’s list price for a drug and the net price to a third-party payer after rebates.

His solution is to migrate brand-name pricing from today’s formulary rebates to up-front discounts. As I explain below, such a shift would radically disrupt the business models and economics of pharmacy benefit managers (PBMs), wholesalers, and pharmacies. I speculate that the change would be negative for the channel.

Right now, most people believe that we’ll continue to muddle along with our Rube Goldberg system. But if Dr. Gottlieb is confirmed as FDA commissioner, then perhaps we will see a black swan event—a massively important yet unexpected break from current practice. Hmmm…


Dr. Gottlieb’s most complete written commentary on the drug channel system comes from his October 2016 testimony to the Senate Committee on Health, Education, Labor, and Pensions (HELP).

Within the U.S. distribution and reimbursement system, manufacturers’ rebates to PBMs and other third-party payers do not flow through wholesale or retail channels. Distribution channel participants—pharmacies and wholesalers—do not have access to information about rebate or discount transactions between manufacturers and PBMs. Consequently, they don’t know the true net price (after third-party payer rebates) of a brand-name drug.

In his testimony, Dr. Gottlieb showed keen understanding of the potentially dysfunctional aspects of this system:
“The problem is that our current system provides incentives for companies to push list prices higher, only to rebate the money later on the back end. Yet the rebates don’t benefit consumers equally and they don’t necessarily help offset the costs paid by those who need a particular drug. The rebates eventually make their way back to health plans to help offset the collective costs of premiums.
But if a patient needs a particular drug, they will increasingly find that they are paying the full, negotiated price at the pharmacy counter. They never see the real ‘net’ price, after the rebate is applied much later. The rebate is paid to the health plan, not the patient buying the drug.”
Dr. Gottlieb further highlights how mandatory rebates in Medicaid and the 340B Drug Pricing Program also help push list prices higher.

His key policy solution would permit more-flexible frameworks for discounting. Here is his crucial comment:
“A discount would potentially be far more equitable, transparent, and pro-competitive than a rebate—especially where the rebate does not flow evenly to all consumers. Increasingly, it’s consumers who are underinsured or uninsured that are stuck paying the full list price at the pharmacy counter. If the ‘rebate’ came in the form of up-front discounts, rather than back-ended givebacks, more consumers who are underinsured would benefit from the negotiated ‘real’ price.”

Dr. Gottlieb’s suggestion implies a radical shakeup of the current system. While the risk of change seems small, it would represent a profound industry disruption for the drug channel.

As a thought experiment, here are my speculations on what would happen if there was an industry-wide shift from back-end formulary rebates to up-front sales discounts.

1) The role and influence of PBMs in formulary selection would vanish.

Today, PBMs encourage manufacturers of therapeutically comparable brand-name drugs to compete for placement on the plan sponsor’s formulary—or even to avoid being cut from the formulary. A PBM will recommend preferred status on the formulary for those products that offer the most competitive rebates, along with evidence-based efficacy and safety. These rebates are the largest and most significant single component of manufacturers’ gross-to-net differences. See Section 5.3. of our 2017 Economic Report on U.S. Pharmacies and Pharmacy Benefit Managers.

As I see it, Dr. Gottlieb is implying that these back-end rebates would become sales discounts paid to distribution channel intermediaries. Manufacturers would therefore sell brand-name drugs in a manner similar to the way that generics are purchased. PBMs do not receive rebates from manufacturers of generic drugs.

Rather than relying on list prices, PBMs and other third-party payers would reimburse pharmacies based on the estimated acquisition cost after accounting for these discounts. A brand-name prescription would be reimbursed based on a Maximum Allowable Cost (MAC) limit or its average acquisition cost (AAC) instead of being linked to Average Wholesale Price (AWP) or Wholesale Acquisition Cost (WAC). 

2) Consumers’ coinsurance would be based on net price, not list price.

Third-party payers increasingly discriminate against the few patients taking specialty drugs. They do this by instituting economically debilitating coinsurance—in some cases with no limit on out-of-pocket expenses. As Dr. Gottlieb pointed out, manufacturer rebates do not get passed through to the point of sale, so coinsurance is based on the drug’s list price. (See Employer Pharmacy Benefits in 2016: More Specialty Drug Cost-Shifting Means More Problems for Patients.) Medicare beneficiaries whose plans have coinsurance also feel the impact of high list prices, as CMS highlighted in its DIR report.

Dr. Gottlieb’s vision implies that coinsurance would be based on the net discounted price paid by the channel, not based on the list price. Here’s how he framed the issue in his October testimony:
“As more consumers find themselves on health plans that have adopted very high deductibles, that also use closed and narrow drug formularies that leave a growing number of important medicines completely uncovered, and that use fixed coinsurance rather than fixed co-pays as a way to distribute costs to consumers, these conditions mean that the high list prices on drugs are the prices being paid by a growing number of consumers when they buy medicines at the pharmacy counter…
In the end, insurers may ultimately pay a price for a medicine that is half the ‘list’ price paid up front by the consumer. And the consumer never receives the direct benefit of the rebate, which gets paid to the insurer. This is precisely the circumstance that occurred for many consumers who purchased EpiPen at or near its list price.”
3) Revenues at wholesalers, pharmacies, and PBMs would collapse. Profits would become more visible.

Today, the revenues of channel intermediaries—PBMs, wholesalers, and pharmacies—are based on brand-name list prices. That’s why these companies are among the largest businesses on the Fortune 500 list. (See Profits in the 2016 Fortune 500: Manufacturers vs. Wholesalers, PBMs, and Pharmacies.) It’s also why McKesson’s CEO whined when drug list prices rose more slowly than they had in the past. (Seriously. See What McKesson’s Profit Warning Means for Manufacturers and Pharmacies.)

A shift to net prices would remove the revenue inflation caused by quadruple-counting of prescription revenues within the channel. It would also expose the true profits of channel intermediaries.

Consider wholesalers, which have low single-digit operating margins (operating profits as a percentage of revenues). This metric can be deceptive, because it is computed using a wholesaler’s revenues—which reflect the fact that a wholesale intermediary “takes title” (legal ownership) to products that it resells. Given wholesalers’ significant revenues, the dollar amounts of these operating profits can be substantial. For example, a 20-basis-point (0.20%) increase in operating margins for a company with $100 billion in revenues translates into an additional $200 million of operating profit.

Consider a brand-name drug with a 50% rebate. If that rebate were converted to a discount, then the wholesaler’s revenues would drop by 40%. A 2% operating margin would now appear as a 4% operating margin. As I note in Section 4.7. of our 2016–17 Economic Report on Pharmaceutical Wholesalers and Specialty Distributors, wholesalers currently retain 40% to 50% of their gross profits into operating profits.

4) Wholesalers and PBMs would radically restructure their agreements with manufacturers.

Brand-name manufacturers’ agreements with wholesalers and PBMs are usually based on list (or gross) prices for prescription pharmaceuticals. In my experience, many executives at brand-name manufacturers believe that these intermediaries are vastly overpaid when WAC-based channel compensation models are utilized.

Consider the following example:
  • A wholesaler earns a buy-side fee equal to 2.5% of a manufacturer’s gross sales plus a 2% cash discount. The wholesaler’s total buy-side margin is therefore 4.5% of a drug’s list price.
  • The manufacturer offers a 50% rebate to a PBM. The manufacturer’s net price will be 50% of the gross price.
  • In this scenario, the wholesaler’s fee equates to 9.0% of net sales—almost twice the fee computed on gross sales.
Similarly, a PBM’s admin fee grows along with a manufacturer’s list price. Using the example above, a PBM admin fee of 5% of WAC translates to 10% of the net price after the rebate. Manufacturers of innovative therapies rightly question the value they receive from these fees.

BTW, Dr. Gottlieb’s suggestion is precisely the type of system change that I describe in Section 6.1.3. of the 2016–17 wholesaler report .

5) Distribution intermediaries will gain influence as power buyers.

As I note above, a shift to up-front discounts would make the brand-name drug channel look more like the generic drug channel.

We’ve already seen what’s happened there. The largest wholesalers and drugstore chains have entered into new combinations that aggregate generic purchasing power. We estimate that in 2016, the four largest buyers accounted for almost 90% of total U.S. generic drug purchases from manufacturers. (See Section 9.3.4. of our 2017 pharmacy and PBM report.)

PBM-owned and insurer-owned central-fill mail pharmacies with substantial specialty operations constitute 6 of the of the industry's largest 15 pharmacies. (See The Top 15 Specialty Pharmacies of 2016.) PBMs may be unable to retain their position if they are no longer able to influence plan sponsors’ choice of dispensing channels.


Nassim Nicholas Taleb names three criteria for identifying a Black Swan event:
“First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. Second, it carries an extreme 'impact'. Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable.”
Dr. Gottlieb’s proposal would be a black swan event for U.S. drug channels.

Before you dismiss this article as a completely impossibility, I suggest you review Mylan’s EpiPen strategy, which involves the simultaneous marketing of (1) a $608 EpiPen with rebates and (2) a $300 EpiPen without rebates. (See The Weird and Wild Gross-to-Net Adventures of EpiPen and Its Alternatives.) Dr. Gottlieb’s vision implies that the brand-name industry should move to the second EpiPen option.

The Wall Street Journal published A Doctor to Heal the FDA, an editorial that is very supportive of Dr. Gottlieb;s nomination. The WSJ points out that Gotlieb will have his hands full reforming the FDA—not to mention overseeing the implementation of the Drug Supply Chain Security Act (DSCSA).

But I wonder how his views will influence the current administration. Of course, Drug Channels will share that  black swan's musical and far reaching bugle-like sound.

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