Editor’s Note: This analysis is part of the USC-Brookings Schaeffer Initiative for Health Policy, which is a partnership between Economic Studies at Brookings and the University of Southern California Schaeffer Center for Health Policy & Economics. The Initiative aims to inform the national health care debate with rigorous, evidence-based analysis leading to practical recommendations using the collaborative strengths of USC and Brookings. This article originally appeared in Health Affairs on September 12, 2017.
Brand and generic prescription drugs dispensed by retail pharmacies cost nearly $400 billion and accounted for more than 10 percent of health care spending in 2016. Despite totaling more than $100 billion, reimbursement for generic drugs has received relatively little policy attention. The combination of a complex distribution system and limited information about actual prices artificially inflates what patients and insurers pay retail pharmacies for generic drugs.
A recent study by the Washington State Office of the Insurance Commissioner confirms that retail pharmacies profit more when dispensing generic versus brand drugs.
Opportunities exist to lower spending on generic drugs—and reduce total health care spending. After summarizing key trends and factors in the generic drug market, this post outlines a proposal to selectively disclose de-identified information on generic ingredient costs, which would enable health plans to negotiate reduced reimbursements to retail pharmacies for generic drugs.
The high prices for many brand drugs have understandably dominated public policy discussions: In the case of certain chronic conditions or life-threatening diseases, expensive drug therapies can cost tens or even hundreds of thousands of dollars per patient. Patients purchase almost $300 billion of brand drugs annually from retail pharmacies, where a brand prescription averages $714. Brand drugs account for 73 percent of retail drug spending, despite comprising only 11 percent of prescriptions.
In contrast, generic drugs average about $18 per prescription and constitute low-cost remedies familiar to and accepted by most Americans. Generics currently account for 89 percent of all retail prescriptions and 49 out of 50 prescriptions where generic products exist as substitutes for brand-name drugs. Yet, because retail pharmacies annually dispense four billion generic prescriptions, 11 million every day, spending on generic drugs accounts for 2.7 percent of total health spending.
While dwarfed by spending on brand drugs, generic drugs are undeniably big business. Given their enormous volume, small price reductions would generate significant savings. However, what patients and insurers pay for generic drugs has generally avoided careful scrutiny, other than relatively infrequent cases involving sharp price spikes.
Competition Makes Generic Drugs Low-Cost Commodities
Generic drugs have earned a reputation as the inexpensive therapeutic option, a perception reinforced by health plan formularies, which have patients pay $5.54 on average in cost sharing, leaving the insurer to pay an average of $12.38. When presented with a prescription for a multisource (that is, generic) drug, pharmacists (or their purchasing agents)—not physicians or other licensed prescribers—decide which product to buy, choosing from among competing manufacturers. Pharmacists can choose the product because the Food and Drug Administration has certified the competing generics as “therapeutically equivalent” to the innovator (brand) drug, meaning they are equally effective and essentially identical.
Competition transforms generic drugs into low-margin commodities when multiple manufacturers produce the same drug. In most cases, little room exists to further squeeze the net (or actual) amounts paid for generic ingredients because retail pharmacies—after including all discounts and rebates—pay manufacturers close to their production costs. Low profit margins for generic manufacturers make lowering net generic ingredient costs an unlikely source for achieving significant savings.
Pharmacy Payments to Manufacturers for Ingredients Equal Minor Part of Generic Reimbursement
However, the actual cost pharmacies pay manufacturers to purchase ingredients constitutes a small fraction of what pharmacies are reimbursed, from both health plans and patients, for generic drugs. Unlike the situation with high-cost, brand drugs, the low cost of generic ingredients means pharmacies retain the lion’s share of the average reimbursement for a generic prescription. (Pharmacy retention equals the difference between reimbursement and ingredient costs; pharmacy profits equal retention minus the costs associated with dispensing a drug.) Because pharmacies, not generic manufacturers, are “where the money is,” the opportunity for savings comes from reducing reimbursement to pharmacies for generic drugs. In the case of generic drugs, potential savings could exceed 10 percent—or $10 billion annually.
The ingredient costs actually paid by pharmacies for generic drugs reflect steep discounts from published prices. Unlike brand drugs, where ingredient costs paid by pharmacies track closely to published prices (wholesale acquisition cost or WAC), actual generic ingredient costs average 30 percent of WAC. However, the overall discount of WAC minus 70 percent varies significantly by product and pharmacy.
Pharmacies, manufacturers, and pharmacy benefit managers (PBMs) regard actual ingredient costs as confidential trade secrets. As a result, health plans typically critically rely on PBMs to design and administer their drug benefit, including establishing formularies, setting beneficiary cost sharing, and negotiating price concessions (rebates) with brand manufacturers. Additionally, PBMs establish a plan’s network of participating pharmacies and set reimbursement to pharmacies. However, unlike brand rebates, the rebates from generic manufacturers bypass both PBMs and health plans, flowing instead to pharmacies.
Pharmacies and PBMs have first-hand information on actual generic ingredient costs, net of all price concessions. In contrast, health plans commonly lack accurate information on actual average generic prices paid by pharmacies. In theory, PBMs use their knowledge of actual generic prices to establish efficient prices when reimbursing pharmacies. In practice, PBMs have a conflict of interest: Lowering reimbursement to “brick and mortar” pharmacies would also lower reimbursement to the large mail-order pharmacies they operate. In other words, lowering generic drug reimbursement would lower PBM profitability. Being both a “price setter” and a “price taker” explains part of why PBMs continue to pay pharmacies overly generous generic reimbursements.
Health Plans Encouraged Generic Dispensing by Overpaying Pharmacies
Setting reimbursement so that pharmacy retention for generic drugs exceeds brand retention incentivizes pharmacies to substitute generic for brand products. Before generic dispensing became ubiquitous, generously paying pharmacies to increase generic use created a “win-win”: Pharmacies made more money, and health plans paid less (because generic ingredients cost markedly less than brand ingredients). But the figure for generic prescriptions as a share of total dispensed prescriptions (generic dispensing) reached 89.0 percent in 2016, having risen from 17.3 percent in 1980, to 32.0 percent in 1990, to 43.0 percent in 1997, to 63.5 percent in 2009. The current high rate of generic dispensing reflects the elimination of beneficiary skepticism about generics, which had been fostered by brand manufacturer activities designed to protect their market share (counter-detailing), as well as the elimination of related concerns about the quality of “cheap” products. Health plans have played a key role promoting generics, both by rewarding pharmacists for dispensing generics and widely adopting benefit designs (three-tier formularies) that charge beneficiaries sharply lower cost sharing for generic drugs.
Significant Changes in the Retail Pharmacy Market
In addition, over the past decade, three important trends have roiled the pharmacy market and provided health plans with new tools to promote generic dispensing and lower pharmacy retention. First, Medicare Part D set explicit “geo access” standards, providing an objective basis for determining the adequacy of pharmacy networks. Second, narrow networks of “preferred” pharmacies have become common, replacing broadly inclusive networks. Third, following the lead of Walmart, big-box and grocery stores, along with some drug store chains, have widely adopted the practice of offering many common generic drugs for a total reimbursement of “$4 per prescription”; this has undermined claims by pharmacies that the estimated cost—and minimum pharmacy retention necessary—to dispense a drug is $11.
The combination of increased pharmacy competition and extraordinarily high generic usage has changed the retail pharmacy market, providing health plans with the ability to negotiate lower reimbursement. Paying pharmacies more to dispense generics may have outlived its usefulness, given that generic drugs account for nine out of every 10 prescriptions and 97.6 percent of prescriptions where there is a choice between brand and generic products. For areas of the country that contain the overwhelming majority of the population, health plans could selectively contract with a subset of competing pharmacies, using the economic pressure of excluding pharmacies from narrow networks to lower pharmacy retention.
Why High Pharmacy Reimbursement Persists for Generic Drugs
In addition to beneficiaries’ desire for convenience and the political power of independent pharmacists, three important factors help explain why pharmacy reimbursement for generic drugs nevertheless remains high. First, for many health plans, lowering generic reimbursement is not a priority, given the low per-prescription cost and the cost pressures generated by other services. Second, health plans frequently do not know the “net” prices pharmacies pay for generic drugs, which are both very complicated and not public. The low priority health plans assign to lowering generic reimbursement may in part reflect their lack of awareness of pharmacy retention for generic drugs.
Third, as noted, PBMs wear multiple hats in the generic distribution chain, creating an information asymmetry and a conflict of interest. PBMs almost certainly play a key role in keeping pharmacy reimbursement high. Their role as mail-order pharmacy operators not only gives PBMs detailed knowledge of actual (net) generic ingredient costs, but they also receive revenues from generic drug manufacturers’ rebates. PBMs thus have a conflict of interest based on their dual roles as the agents of health plans in setting pharmacy reimbursement and the operators of pharmacies of their own.
Collecting and Selectively Disclosing Actual Average Generic Ingredient Costs
After analyzing the generic drug distribution market, a USC-Brookings Schaeffer Initiative Paper presented earlier this summer proposed a policy of selective disclosure to health plans of actual average generic acquisition costs. Building on the requirement that they must be licensed, all drug wholesalers would have to report weekly to the Centers for Medicare and Medicaid Services (CMS) the average net generic drug price reflective of all rebates for each 11-digit national drug code in a standard, electronic manner. Using the collected and securely stored data, CMS would calculate actual average acquisition costs, which would be reported to participating health plans that agreed to strict confidentiality.
CMS would have broad flexibility to tailor reported price transparency to product-specific circumstances (for example, the number of competing manufacturers) and would assure that reported averages could not have the prices associated with specific manufacturers, wholesalers, or pharmacies be re-identified. These provisions are intended to minimize the concerns of antitrust authorities about the potential for price transparency to facilitate price collusion. User fees charged to participating health plans would defray CMS costs of securely communicating the data on a biweekly basis.
Providing health plans with actual average generic ingredient costs would rebalance the current information asymmetry between most health plans and PBMs. Knowing actual average generic costs would highlight the level of pharmacy retention and enable health plans to better understand the economic consequences of the pharmacy reimbursement terms negotiated on their behalf by PBMs. Given the volume of generic drugs, their widespread acceptance, health plan benefit designs, changes in the pharmacy market, and the conflicting roles of PBMs, making available average generic ingredient costs could motivate health plans to reduce reimbursement for four billion generic prescriptions.
Reducing generic reimbursement by $1 per prescription—5.6 percent—would lower health spending by $5.6 billion annually. If health plans have access to accurate data on generic ingredient costs and are willing to aggressively implement narrow pharmacy networks, our assessment of the pharmacy market suggests that the resulting vigorous competition could cause current generic drug costs paid by plans and beneficiaries to fall by 10 percent.
 We use 2016 quintiles IMS Health data on generic share of total invoice spending, volume of generic prescriptions, and estimates of net price relative to invoice pricing to calculate the average costs of brand and generic prescriptions.
The authors did not receive any financial support from any firm or person for this article or from any firm or person with a financial or political interest in this article. They are currently not an officer, director, or board member of any organization with an interest in this article. Steve Lieberman consults for The Pharmaceutical Research and Manufacturers of America (PhRMA), which represents brand drug manufacturers but not generic drug manufacturers, on issues related to CBO scoring and the budget.