The Perverse Incentives Created by PBM Rebate Arrangements

Recently, Sens. Tina Smith (D-Minn.) and Elizabeth Warren (D-Mass.) wrote letters to several pharmacy benefit managers questioning their role in rising drug prices. The senators are right to be concerned.

PBMs, which act as intermediaries between drug insurance plans, drug manufacturers and pharmacies, negotiate rebates from drug manufacturers in exchange for giving the manufacturers’ drugs preferred formulary status (which channels more customers to the drug). Rebates are generally calculated as a percentage of list prices, and PBMs keep a share of the rebates they negotiate. Although this setup gives PBMs the incentive to negotiate larger rebates for their drug plan clients, it also gives them the incentive to encourage list price increases (or at least not discourage decreases) in order to increase their profits.

As an example, for a drug with a list price of $100, a PBM that negotiated a 30 percent rebate would keep a share of the $30 rebate. However, if the drug manufacturer increased the list price to $120, the 30 percent rebate would enable the PBM to earn more money by keeping a share of the larger $36 rebate. This example would harm many patients. Some of insured patients may have cost-sharing obligations that hinge on list prices, and thus will pay more when the list price increases. Other insured patients within the deductible phase and patients without drug insurance will pay the entire higher list price.

The rebates paid to PBMs have oftentimes created a significant divergence between list prices and the net prices that drug manufacturers retain after discounts and rebates. For example, Johnson & Johnson’s Janssen subunit recently reported that, in 2017, it paid $15 billion in rebates and discounts, which reduced its list prices by 42 percent. As a result, whereas Janssen list prices increased by 8.1 percent across all products, its average net prices declined by 4.6 percent. Indeed, a recent marketwide study reported that the divergence between list prices and net prices was growing, with 2017 list prices for protected brand products increasing by 6.9 percent, while net prices increased by only 1.9 percent.

As market concentration in the PBM industry has increased — according to Food and Drug Administration Commissioner Scott Gottlieb, the top three PBMs control more than two-thirds of the market — PBMs have been able to demand larger and larger rebates from manufacturers. From 2012 to 2016, total rebates increased from $59 billion to $127 billion.

PBMs pass on some of these rebates to their drug plan clients, who can then use them to lower premiums for all covered individuals (though recent analysis questions whether they do).  However, oftentimes the amount of the rebate that PBMs keep is either not negotiated or undisclosed, and evidence shows that PBMs keep a sizable share for themselves (see, for example, here and here).

In sum, the evidence shows that drug list prices are increasing, but manufacturers are realizing a decreasing share of total drug spending as the rebates they pay increase. In contrast, PBMs are keeping an increasing share of total drug spending because they keep a sizable amount of these rebates. Moreover, with both PBMs and drug plans themselves keeping part of the rebate, patients often don’t realize much of the negotiated savings.

Health and Human Services Secretary Alex Azar has recently asserted that PBM rebate arrangements thwart drug companies’ efforts to lower drug prices or restrict price increases.  Azar explained that because PBMs profit more from higher-priced drugs, many drug companies have concerns about lowering prices because “the fear is that they would be discriminated against for decreasing their price.”

Indeed, there is growing bipartisan concern about PBMs’ role in increasing drug prices. In addition to the Warren and Smith letters, a recent report by Democrats on the Senate Finance Committee recognized that “rebates encourage [manufacturers] to set higher list prices to account for price concessions down the road.” The Trump administration’s blueprint to lower drug prices has criticized the role of the PBM rebate structure in increasing drug prices: “What had been a hidden negotiation and wealth transfer between drug manufacturers and PBMs is now a direct increase on consumer out-of-pocket spending.”

To eliminate these perverse incentives to increase list prices, current PBM rebate arrangements should be prohibited, and any discounts that PBMs negotiate with drug manufacturers should be applied at the point-of-sale. Upfront discounts rather than retroactive rebates will ensure that patients benefit from the negotiated savings instead of PBMs and drug plans grabbing a piece before savings can trickle down to patients.

Moreover, PBM compensation should not be based on negotiated discounts off list price; otherwise, the current incentives of manufacturers to increase list prices will remain. With enough competition in the market, PBMs should still have the incentive to vigorously negotiate for discounts, and manufacturers will compete for formulary status based on the discounts they offer rather than the rebates they pay.

The elimination of current PBM rebate arrangements will also remove an important obstacle deterring manufacturers from voluntarily lowering drug prices. Several major drug manufacturers, including Allergan, Novo Nordisk, AbbVie and Takeda, have publicly committed to limiting drug price increases, and pricing data confirm that several companies have restricted price increases to single-digit increases.

As lawmakers consider government intervention in the drug market in order to reduce prices — interventions that would produce negative, market-distorting consequences — more drug manufacturers would do well to voluntarily constrain their prices. The Department of Justice might also consider providing a limited waiver to facilitate discussions among drug manufacturers about industrywide voluntary price increase limits — activity that would otherwise raise antitrust concerns.

Joanna Shepherd is a professor of law at Emory University School of Law and the author of several studies examining the impact of government price controls on drug prices.

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