High and ever-increasing drug prices are a growing concern among consumers and policy makers, and a particular focus of late has been on the drug “rebates” that drug companies provide to pharmacy benefits managers (PBMs). Indeed, the Centers for Medicare and Medicaid Services (CMS), the FDA, and Congress are each threatening to take steps to reduce or eliminate them altogether, asserting that doing so would lead to lower drug prices.
However, the notion that competitively negotiated drug rebates are the cause of high drug prices rather than the pricing behavior of drug companies belies rational economic analysis. Rebates are the current bogeyman because few people—including policymakers—have an understanding of the role of rebates and why they are used.
Rebates are the mechanism through which insurers and PBMs achieve discounts from the “list” price for drugs. It is similar to the negotiations that occur in the managed care industry with physicians and hospitals: in that venue, insurers obtain a “contractual allowance” that is similar to the drug rebates in providing a discount from list price for health care services. Health care costs—and by extension health insurance premiums—would be multiples higher than they currently are were it not for the negotiated discounts obtained by insurers. Similarly, drug costs would be considerably higher absent rebates.
Some observers unfairly imply that they are nefarious “kickbacks” that PBMs use to pad their profits. This effort at misdirection is primarily done to avoid looking at the pharmaceutical company’s effectively unbounded list prices for drugs.
This raises a question: Why do PBMs negotiate for rebates rather than just lower prices?
There are several institutional details that make rebates a preferred and at times the only legal mechanism available. For starters, the “list” price for a drug is largely irrelevant; few consumers pay list price for any health care services, either for drugs or physician visits. In one sense a hospital’s “list” price is akin private university’s posted tuition: a high list price for tuition allows a school to milk a lot from a few wealthy people while everyone else gets some sort of discount. In neither case does the list price reflect the underlying cost of the good or service being provided.
While this system of high prices and rebates may have few parallels in our consumer market, the health care market is a vastly different beast: Since insurance pays the bulk of drug costs and doctor’s visits for most people in exchange for a monthly payment from us or our employer, we do not have much reason to economize on our health care services or to look for lower prices. Instead, it is up to our insurance companies to do so. They have an incentive to negotiate lower prices for both drugs as well as hospital and doctor office visits for their enrollees.
The rebates that PBMs obtain for their insurance company clients effectively reduce their operating costs, which in turn helps keep the cost of insurance low. To assume that this particular method of reducing costs accrues solely to the provider in the form of excess profits is nonsensical; insurance companies do face competition: none has a guaranteed client for the indefinite future that does not care about cost.
Second, much of the broader conversation regarding drug prices, rebates, and PBMs conflates the normal market process with the elaborate system enshrined in the Medicare Part D drug program for seniors. The Part D program adds additional distortions that often tie the hands of the PBM and at the same time create incentives for the drug companies to raise prices. Consumers can potentially end up worse off when they pay cost sharing based on the high drug company list price instead of the post-rebate net price. However, in a competitive Part D drug plan environment, it is likely that the plans offset these costs with lower premiums.
The third and arguably most important reason rebates make sense is competition—or rather the lack thereof. For instance, while the government closely scrutinizes hospital mergers out of concern that greater market concentration leads to higher prices, we also award patents—effective monopolies—to drug companies who develop a unique, safe and effective drug.
Patent protection is of course a concession made to encourage companies to innovate, and despite a few abuses here and there (pharmaceutical company pay-for-delay practices to limit generic competition come to mind), it has driven much of the remarkable progress we have seen in the drug market the past few decades.
But this does not mean that drug companies have the best interests of consumers in mind when it comes to pricing. The cost of drug development and the many failures along the way to a successful product are “sunk” costs, and the drug companies want to make that up—and then some—on what they charge for a pill. What is important is that there is a flexible, competitive, and balanced negotiating process between drug companies and insurers and PBMs to drive drug prices down. Rebates are price reductions—which is precisely why drug companies are leading the effort to demonize them.
Health care payment policies are arcane and complex, and as long as third parties like insurers and the government play such a large role in the market it is hard to see how they will ever become simpler, and it is not clear that simplicity should even be a goal. Instead, our goal should be that the market fosters competition between parties whenever possible. The government should try to find ways to best facilitate that competition, not stifle it.
In the health care world, we often speak about “second-best” solutions because the first-best solutions derived from economic theory are unattainable. Drug rebates are without a doubt not the first-best solution for the market, but unless we go to a system where no one uses insurance and we all deal directly with health care providers, rebates are a part of our second-best solution.
A world without rebates is a world in which everyone pays higher premiums for health insurance and drug companies make higher profits without doing anything to earn them.
