Wednesday, October 11, 2017

Thanks, California! SB17 Will Trigger Massive Speculative Buying, Windfall Pharmacy Profits, and Supply Chain Disruption

California governor Jerry Brown has just signed SB-17 – Drug Price Transparency into state law. Click here for the official summary.

This law is truly nutty. It won’t accomplish much of what it purports to do.

Below, I focus on the provision that requires manufacturers to provide 60 days’ advance notice of increases in a prescription drug’s Wholesale Acquisition Cost (WAC) list price.

As I explain, this requirement ignores crucial drug channel and supply chain economics. Consequently, mandating advance notice of price increases will benefit pharmacies and hospitals, not third-party payers. The new law also ignores what we’ve learned from the wholesale channel’s evolution more than a decade ago.

To mitigate some of the disruption, manufacturers should pay special attention to trade agreements with wholesalers and pharmacies. Everyone else should shake their head in wonder and despair for healthcare policy making in our country.


As background, see Ian Spatz’s great editorial from the Health Affairs blog (See California Takes On Drug Pricing: Real Progress Or Illusion? It’s a nice summary of SB17’s many flaws and unintended consequences.

I’m going to focus on the price notification aspects of SB17. These are contained within section 127677:
(a) A manufacturer of a prescription drug with a wholesale acquisition cost of more than forty dollars ($40) for a course of therapy shall notify each purchaser described in Section 127675 if the increase in the wholesale acquisition cost of a prescription drug is more than 16 percent, including the proposed increase and the cumulative increases that occurred within the previous two calendar years prior to the current year. For purposes of this section, a “course of therapy” is defined as either of the following:

(1) The recommended daily dosage units of a prescription drug pursuant to its prescribing label as approved by the federal Food and Drug Administration for 30 days.

(2) The recommended daily dosage units of a prescription drug pursuant to its prescribing label as approved by the federal Food and Drug Administration for a normal course of treatment that is less than 30 days.

(b) The notice required by subdivision (a) shall be provided in writing at least 60 days prior to the planned effective date of the increase. (emphasis added)

(c) (1) The notice required by subdivision (a) shall include the date of the increase, the current wholesale acquisition cost of the prescription drug, and the dollar amount of the future increase in the wholesale acquisition cost of the prescription drug.

(2) The notice required by subdivision (a) shall include a statement regarding whether a change or improvement in the drug necessitates the price increase. If so, the manufacturer shall describe the change or improvement.

(d) The notice required by subdivision (a) shall be provided to each state purchaser and other purchasers described in paragraphs (2) to (4), inclusive, of subdivision (a) of Section 127675 if a purchaser registers with the office for the purpose of this notification. The office shall make available to manufacturers a list of registered purchasers for the purpose of this notification.

(e) If a pharmacy benefit manager receives a notice of an increase in wholesale acquisition cost consistent with subdivision (a), it shall notify its large contracting public and private purchasers of the increase. For the purposes of this section, a “large purchaser” means a purchaser that provides coverage to more than 500 covered lives.
The bolded sentence in 12677(b) contains the price notification requirement.


Pharmacies and healthcare providers will become the primary beneficiaries of SB17’s requirement that pharmaceutical manufacturers provide advance notice of WAC price increases. Payers and patients will see limited gains. The state of California will see no appreciable benefit.

This unexpected result will occur because the revenues and profits of pharmacies are linked directly to brand-name list prices. By providing advance notice of a price increases, pharmacies will have enormous incentives to purchase extra inventory and earn windfall profits. These profits do not have to be shared with third-party payers or patients.

The table below shows a hypothetical example. For brand-name drugs, a pharmacy’s reimbursement from third-party payers is typically computed as a percentage of a brand-name drug’s Average Wholesale Price (AWP) list price, which is computed from WAC. In the “base case,” the ingredient cost reimbursement is AWP-16.00% and the pharmacy’s profit per prescription is $16.40. Background for this figure appears in Follow the Dollar Math: How Much Do Pharmacies, Wholesalers, and PBMs Make From a Prescription?

[Click to Enlarge]

After the manufacturer increases the WAC price, the pharmacy earns substantial inventory profits on product purchased at the old price. This means that the pharmacy has purchased the drug at the old WAC price, but can be reimbursed based on the new WAC price.

In the example above, the pharmacy’s profit jumps to $46.44 per prescription. Pharmacies would make money as speculators rather than as product dispensers. However, third-party payers reimburse the pharmacy based on the new list price, so it would experience no savings. Eventually, pharmacy profits would decline again as pharmacies purchased inventory at the new price.

Third-party payers could also adjust the AWP discount to normalize profits. In the example above, pharmacy profits would be comparable to the base case with an ingredient cost reimbursement of AWP-16.31% after the price increases. Otherwise, the dollar value of a pharmacy’s gross profits would remain high, because reimbursements are computed based on the new price.


Normally, pharmacies are uncertain about the precise timing of a manufacturer’s price increases. By providing 60 days of advance notice, the pharmacy can speculatively purchase extra inventory and earn an almost risk-free profit.

Specialty pharmacies will be especially motivated to play this game. PBM-owned and insurer-owned central-fill mail pharmacies with substantial specialty operations dominate pharmacy dispensing activity. (See The Top 15 Specialty Pharmacies of 2016.) I wonder if SB17’s author intended to help such companies as CVS Health, Express Scripts, Walgreens Boots Alliance, and UnitedHealth Group?

Patients would not benefit. Many patients are being asked to pay a greater share of prescription costs for more-expensive specialty drugs, because of high coinsurance amounts. (See Employer Pharmacy Benefits in 2016: More Specialty Drug Cost-Shifting Means More Problems for Patients.) These patients will be stuck paying coinsurance based on the list price and will see no benefit from a more favorable acquisition cost to a pharmacy.

The requirement in 12677(e) that PBMs notify "large purchasers" won't really help. Third-party payers will still not know how much inventory a pharmacy is holding. Plus, pharmacies outside of California won't be subject to any oversight from that state.

Third-party payers also wouldn’t benefit from advance notice of price increases for drugs that are administered by healthcare providers in an outpatient setting, such as a physician’s office or an outpatient clinic. These drugs are reimbursed primarily on the basis of the Average Sales Price (ASP), as I describe in Latest Data Show That Hospitals Are Still Specialty Drug Profiteers.

ASPs are published with a two-quarter lag between the time of a manufacturer’s sale and when the sale becomes the basis for a payment amount. Today, third-party payers pay less than current market price until the published ASP catches up to the actual price. Advance notice will encourage providers to stock up on drugs that will have a subsequent ASP increase. The profits will continue until the published figure catches up to the sales price.


As I explain in Section 4.6.2. of our new 2017–18 Economic Report on Pharmaceutical Wholesalers and Specialty Distributors, drug wholesalers will benefit very little from the new law’s advance purchasing of inventory.

That’s because inventory profits are eliminated by almost all manufacturer-wholesaler distribution service agreements. Manufacturers typically negotiate agreements that recapture the value of price appreciation on inventory held in wholesalers’ warehouses and on order with the manufacturer. If a manufacturer recaptures the full inventory appreciation value, then a wholesaler does not benefit from buying inventory at the old price and then selling it at the new, higher price.

Before such agreements were adopted, more than 10 years ago, most drug manufacturers compensated drug wholesalers by letting them purchase more product than was required to meet customer needs. In that era:
  • Pharmaceutical wholesalers engaged in aggressive investment buying, in which they actively sought to maintain higher inventory levels of prescription drugs than were needed to meet short-term demand from wholesalers’ customers. The wholesalers would hold the extra inventory, selling it whenever prices increased.
  • Thousands of companies sprang up to buy and sell the excess channel inventory in a virtually unregulated secondary market, creating opportunities for criminals to introduce counterfeit and mishandled products into the U.S. drug distribution system.
For a brief historical background, see Drive the Right Pharmaceutical Supply Chain Behaviors, my Harvard Business Review Supply Chain Strategy article published in 2005.

In response to these challenges more than a decade ago, manufacturers and wholesalers began signing contractual agreements limiting the product inventory that a wholesaler could hold. These agreements evolved into today’s broader distribution service agreements (DSA) agreements between manufacturers and wholesalers.

Consequently, SB17 should encourage manufacturers to begin exploring direct inventory management relationships with key pharmacies to minimize speculation and the accompanying risks of drug shortages and diversion. It will be tough to negotiate these agreements, because pharmacies will see the lure of big profits.


All of this speculative purchasing will wreak havoc with pharmaceutical supply chains. What were California’s legislators thinking? Do they have any idea how little California will benefit from advance notice? What will happen to the excess inventory and higher pharmacy profits generated by California’s new law?

Don’t ask the people who wrote the bill. They seem completely oblivious to SB17’s actual impact.

Ed Silverman at Pharmalot conducted a very revealing interview with California state senator Ed Hernandez, the Democratic legislator who “shepherded the bill.” (See Q&A: Can the California law on drug pricing transparency make a difference?)

Ed gamely tries to pin down Senator Hernandez on how exactly the bill will make a positive difference. Senator Hernandez seems unable to articulate any particular mechanism of action. His perspective appears to be: “Well, we did SOMETHING.”

Apparently, whether SB17 was the right thing—or even a useful thing—was a secondary consideration.

Thanks, Governor Brown!

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