Branded Drugs are upside down

Why does the pharmacy market treat the highest ticket items as a loss leader for the lowest ticket items?

If you walk into an independent pharmacy and ask them how much money they make on branded drugs, you’ll probably hear several curses about PBMs (and maybe about wholesalers). This is because the market for branded drugs is upside down for pharmacies. A few points of fact as I understand them from talking to wholesaler executives (if you have evidence to the contrary, please tell me!):

1) All wholesalers purchase branded products from manufacturers at the WAC price.

2) in the past, wholesalers would make money by purchasing large quantities of branded products prior to a predicted price increase by the manufacturer and pocket the difference between the buy/sell price over time. This caused problems for manufacturers who would see dramatic changes in demand over the course of a year – massive orders placed in december, no orders in january, february or march, right after they took a price increase. This led to manufacturing facilities working overtime and then idling for months – not an ideal situation when you have processes that work best with relatively constant production.

3) As I understand it, Cardinal Health proposed a solution to this impasse – the “Inventory Management Agreement” or IMA. Under this agreement, Cardinal would agree to maintain inventory levels in certain bounds at their warehouses – they’d keep, for example, between 4 and 8 weeks of supply of a given product on hand – no more (leading to the boom-bust problems experienced pre-IMA) and no less (leading to shortages at pharmacies). In exchange, the manufacturers would pay the wholesaler a small percentage of the sales price (generally 0.5-1.25% of WAC – lower for established products, higher for newer manufacturers trying to get market access) of the items they stocked as a rebate, which was contingent on keeping the par levels at the wholesaler’s warehouse within the bounds of the IMA agreement. Other wholesalers adopted the same model shortly thereafter. In addition, the manufacturer gives a tiered discount on the WAC (again as a rebate) in exchange for prompt payment (for example - 0% for payment in 120 days, 0.5% for 90 days, 1% for 60 days, 1.5% for 45 days and 2% for payment within 30 days). Wholesalers do also retain the value of price increases on inventory in their possession at the time of a price increase (as evidenced by the 10-k filings of the major wholesalers), but this is a blunted part of their margins.

4) Adding the two rebates together, wholesalers purchase branded products at WAC and then receive a rebate of approximately 2.5 to 3.25% of WAC. These discounts are supposedly pretty much identical across wholesalers from small regionals to the big 3.

5) Due to the FirstDataBank settlement in 2008, for branded medications, AWP is equal to WAC times 1.20. This means that a pharmacy’s margin on each prescription can be calculated to the penny for any given brand name medication, provided you know their Prime Vendor Agreement WAC discount and the PBM’s contract terms.

NADAC for branded products is observed to be at WAC minus a 4% discount according to the NADAC equivalency metrics. How is this possible? 4% of WAC is more than 3.25% of WAC. That doesn’t make sense, does it? When I observe the price files of pharmacies across the country, I note repeatedly that pharmacies that utilize smaller, regional wholesalers tend to have higher branded prices (in line with the acquisition costs of the wholesalers plus a small markup). Pharmacies that utilize the big 3 wholesalers have below-wholesaler-cost branded invoice prices. What’s going on here?

It’s pretty simple – it’s cost-shifting. Pharmacies commonly notice that generic products are much cheaper outside of their prime vendor agreement than inside of it. The biggest wholesalers are playing a game of monte – they move their costs for brands to their costs for generics in a contingent manner – pharmacy owners that pay attention to the details of the PVA will notice that branded products decrease in cost as the purchase volume of generics increases – in a bounded way – you have to maintain a large enough proportion of generic purchases to branded purchases to qualify for more aggressive branded COGS. Do the math on your deal and its pretty simple math to figure out where that discount came from. A wholesaler might, for example, offer an invoice price of WAC minus a 4% discount on up to $50,000 of product in exchange for purchasing at least $4,000 of generics. If we take the wholesaler’s cost to be WAC minus 2.5%, then to break even on this agreement, they need to make at least 1.5% of WAC in profit on the generics - $750 of profit on generics to fund $50,000 in below cost brands. It’s not hard to imagine a wholesaler having $750 of profit on $4000 of generics if you’ve ever compared Masters or RiverCity prices to McKesson prices, or SmartSource prices to AmeriSource prices, or ParMed prices to Cardinal prices (these are the generic secondary companies owned by the big 3 wholesalers, so I believe their prices to be much closer to the wholesalers’ acquisition price).

There are a lot of pharmacy owners that don’t believe me when I explain this, and believe that in some way the big wholesalers are making big bucks on branded products. I challenge this belief with a simple empirical test – ask a big 3 wholesaler if you could buy brands from them at WAC minus 6% without buying any generics from them at all. (aside: there are places where you can occasionally legitimately get some branded products for less than WAC without companion generic sales, but those sources have chosen to forego the IMA rebates in favor of the old buy, hold till price increase, sell model. As WAC price increases have moderated from ~9% per year to closer to 3% per year, these sources have become even less reliable and certainly less aggressive in their pricing). Branded products priced at less than WAC minus a 3% discount are either a) contingent on generic purchases, b) a wholesaler used the old model and won’t have consistent supply or c) another pharmacy is trying to offload unused inventory that cannot be returned for credit or d) illegitimate product.

Pharmacy owners should be aware that despite the efforts of the FDA and congress in creating the DSCSA, illegitimate product continues to exist – it enters the supply chain in several ways – con-man schemes against pharmacies (like almost happened to my practice a few months ago), con-man schemes against wholesalers (a fraudulent recall notice is sent via fax to a wholesaler warehouse and then a con-man shows up shortly afterwards to “take back the recalled product”), fraudsters buying a patient’s medications back from them after dispensing a prescription to them and then reselling that product, and just outright counterfeiting. If someone offers you branded product consistently at a price that is less than WAC minus 5% without a requirement to buy a lot of generics, you should contact the FBI and board of pharmacy, not buy the product. In other words, if it looks too good to be true, it is.

The big Pharmacy Benefit Managers and big wholesalers deserve a lot of blame in my view for the problem of illegitimate product on the market. Branded products cost wholesalers WAC minus a 2.5-3.25% discount, or, in other words, AWP less an 18.75-19.375% discount. Pharmacy reimbursement contracts below that point should frankly be illegal, because they mean that the only way to profitably and consistently fulfill that contract is to purchase illegitimate product. The largest wholesalers also deserve blame for facilitating the perception that reimbursement contracts below that point are possible to fulfill legitimately and profitably through their anticompetitive pricing schemes. The big 3’s pricing schemes have made for a situation where the NADAC for brand products is below the wholesalers’ cost of acquisition. NADAC is the basis of most state medicaid programs reimbursement to pharmacies for drug product. The existence of a below-wholesaler-cost-NADAC has led to a scenario where customers of smaller wholesalers are at a structural disadvantage to customers of large wholesalers.

Any nuanced look at the prescription drug market has to recognize that there are two markets for prescription drugs: brands and generics. The generic drug market today largely functions as you would expect a competitive market to work – many manufacturers offer their wares at just above the marginal cost of production due to competition, leading to persistent deflation in the NADAC of generic drug products. The branded drug market is not a competitive market – it is a monopoly system of controlled acquisition prices set by single entities who entirely control their product’s pricing to pharmacies. It is also a failed market, because the incentives of the participants (especially pharmacies) are to not participate. There’s a saying in publishing – the first print is sold by indies and the rest by chains. This saying is largely true in pharmacy – the first lot of a new drug is often sold by the indies and the bulk is sold by chains. But in today’s upside down market, indies have no incentive to participate in the branded drug market – the more brands you sell, the more money you lose. This poses a problem for newer manufacturers trying to gain a foothold in national dispensing patterns – if there aren’t any indies willing to mess with your weird secondary billed coupon programs, you don’t get market penetration.

This concept makes me crazy – in pharmacy, unlike in usual retailing, you sell the $4000 TVs (Humira or other brands) as a loss leader so that you can sell more milk (generics) at a crazy markup of like $20/gallon, but it better be the organic oatmilk (zegerid), regular milk (regular omeprazole) has a sales price of $0.52 regardless of your cost of goods.

15 years ago, independent pharmacies were aligned with manufacturers trying to sell a new product – they’d make money on any marginal sales volume, and brands had high revenues and decent margins associated with them. Today, small pharmacies have no alignment with PhRMA companies trying to move new products – they lose money in the effort. Small pharmacies can make money through 340b contract pharmacy arrangements with covered entities, but that’s not aligned with the manufacturers’ incentives either.

I believe that the incentive structures in the market cannot correct themselves at this point. The pharmacy industry is tied in a gordian knot where large wholesalers cannot rationalize their pricing structures to ensure a profit on branded sales without causing pharmacies to abandon those purchases entirely, and PBMs cannot compete in the market for their services without offering their network pharmacies a reimbursement for branded products that is below the cost of acquisition. The solution to a gordian knot is not to try to untie the knot – it’s to sever it. When markets fail, the rational response is to turn to government to restructure the market. My hope is that the government (in the form of the FTC PBM study, for example) will set bounds for the market so that it is a rational system where each actor is fairly compensated for their role in the market. Companies that make innovative products that treat previously untreatable diseases deserve to make money. Wholesalers that facilitate efficient movement of product from production lines to pharmacies deserve to have those operations paid for. Pharmacies that facilitate last mile delivery of these products from wholesaler warehouses to patient homes deserve to make a profit to fund those operations. Fiscal intermediaries like PBMs and insurers should earn reasonable service fees to fund their operations. In other words, everyone who does work should be paid for that work. But right now our system takes money from pharmacies that do work and gives it to the fiscal intermediaries who reap profits entirely disproportionate to the work they put in. That’s the hallmark of a monopolized market – one entity puts in the work, another entity receives the monopoly rents.

Honestly though, I’m not sure what to do about this whole situation. I suppose I foresee a few potential futures:

1) all branded products become “specialty” products that are entirely fulfilled by mail order pharmacies which are subsidized by the PhRMA-PBM rebate schemes. Local pharmacies fulfill generic prescriptions only, and third party coverage of prescriptions therefore becomes entirely irrelevant to local pharmacies. The concept of billing amlodipine or lisinopril or most generics to third parties makes no economic sense – the deadweight loss of billing is higher than the cost of goods and services. Without high dollar branded products in house, pharmacies don’t need PBMs. Claims volume at PBMs drop by a factor of 10 (~90% of prescriptions are generic), and smaller PBMs dependent on per-Rx service fees have their economic model dry up.

2) Governments (federal and state) intervene in the market and participate in rate-setting in the model of most other countries’ pharmacy systems (Canada, for example, reimburses pharmacies a fixed fee per prescription plus a small % of sales).

3) Governments intervene in the market to outlaw various anticompetitive behaviors including rebate walls, cost-shifting between buckets, below cost reimbursements, and patient steering, among other behaviors, correcting the market failures.

4) PhRMA companies come up with a way to reliably reimburse pharmacies for their losses in a way that doesn’t run afoul of anti-kickback statutes.

5) 340b eats the entire supply chain and PhRMA companies stop making any money at all.

The most likely scenario in my view is that within 5 years, small pharmacies become generics only dispensers and opt out of PBM networks. Honestly it actually doesn’t sound too bad from a personal standpoint – pharmacies would set their own prices, and not have to deal with PBM DAW-9 (brand only) mandates, audits, training requirements, coverage policies, PA requirements, transaction fees, etc. But my internal patient advocate is screaming at the injustice of forcing every person who needs any therapeutic that isn’t at least 10 years old to deal with PBM-owned mail order facilities. There has to be a better way. I hope we find it.