Big Pharma’s Response to the Impending End of Drug Rebating…Just Say No!

By Tonic Advisors

Recently, we wrote about how rebates in the pharmaceutical industry can lead to unexpected, unintended and adverse consequences.  Specifically, we noted the following challenges created by rebating:

  1. Misaligned incentives. Insurers may, in some instances, have an incentive to put less effective or more costly drugs on a formulary when they are more profitable, because of the money received from “invisible” rebates, which are hidden from customers.
  2. Increased out-of-pocket costs for patients. Patient out-of-pocket payments are often based on the cost of a drug before the rebate. Patients sometimes pay more than they would have if the price of the drug was simply discounted at the counter.
  3. Decreased transparency. The rebates make the overall economics of pharmaceutical care hard to understand and decipher because so much of the money involved is hidden. Milliman, a leading actuarial company, estimates 22 percent of the drug spend in Medicare and 12 percent of the drug spend in commercial markets are covered by rebates. If you do all the math, the overall value of rebates is about $100 billion.

You might think to yourself, “none of this seems like a good idea,” and “I thought there were anti-kickback laws that prevented this sort of thing?” You would be right– sort of. In most circumstances (any Federal Health Program), rebates or direct payments to organizations or people in a position to make decisions about how care is dispensed, or what options are available, are prohibited by the Anti-Kickback Statute (AKS) (42 USC § 1320a-7b(b)).  For example, a freestanding MRI facility could not provide a $500 kickback for every referral made by nearby physicians.

On its face, a Pharma manufacturer would not be able to provide a rebate to an insurer for every prescription that gets filled for that manufacturer’s drug. The fact that the insurer doesn’t write the prescription doesn’t really matter because insurers can “induce” choice of prescription by deciding what is on formulary and the copayment amount. Yet, as we pointed out in the last article, this is exactly what happens.

The Department of Health and Human Services (HHS) decided to allow certain types of drug discounts that met certain standards to be considered outside of the scope of the AKS (a safe harbor).  Previously, the rebating tactic was not widely used. Once the opening was created, the industry drove a truck right through it. Today, it has become a significant industry driver.

What is changing?

The Trump administration has proposed closing the loophole (for Medicare and Medicaid) that let the truck full of incentives through. They are not changing the law itself. The administration is just closing the safe harbor that had been in place. The safe harbor essentially said that “we don’t think the law was meant to apply to this set of circumstances.” Now the administration is saying in effect “Sorry…that was a misinterpretation. It should have applied to that set of circumstances all along and we are going to make that clear from here on out.” In other words, the proposed rule eliminates protections for manufacturer drug rebates for Medicare part D plans and Medicaid managed care organizations (the exception being any government required rebate programs under Medicaid). It’s important to note commercial markets are out of scope…for now.

The question is, “What will happen next?” This is a lucrative business practice for many people.  There is a lot of money in incentives ($100B) themselves and on top of that is the revenue from the underlying pharmaceuticals that the incentives induce people to buy (much bigger than the incentives themselves). The incentives and rebates allow manufacturers and PBMs to exert significant control over which drugs are bought. In other words, it helps them engineer their profits.

How might this shake out?

  1. It fizzles out. Big Pharma and Big PBMs exert sufficient control over the political process that they quash or water down any elimination of the safe harbor. This is certainly possible but unlikely. It is possible that the closing of the safe harbor will not eliminate rebates entirely. If there is enough of a hole kept open, then the industry will widen it over time back to current levels. On the other hand, greater awareness of the issue could lead to greater vigilance and counter actions on the part of buyers and employer groups. The comment period for the rule has ended and while we expect to see some minor variations to the final rule, as well as additional clarity, we do expect to see the rule implemented.
  2. Whack a mole. Big Pharma and Big PBMs find different ways of accomplishing similar end results using different means. If this rule remains only with Medicare and Medicaid markets for the time being, strategies will inevitably shift to the commercial markets and it is likely the rebates scenario there will only become more pronounced, at least in the short term. Alternatively, manufacturers and PBMs could engage in subterfuge to disguise rebate payments as something else. For example, enhanced administrative, or data integration fees could be created to create an equivalent but even more opaque payment infrastructure.[1]  An “administrative fee” or technology surcharge, could be used as a way of compensating PBMs for certain drug usage patterns (e.g., payment of $X for every prescription of this variety for “data analysis” purposes).  These tactics could be challenged, but it is certain that many tactics will be tested.
  3. The industry adapts positively. The industry could, instead of resisting change, embrace it. Using rebates to drive profits is one way to make money. There are others.  Pharmacy Benefit Managers do pretty much what their name sound like. They manage the pharmaceutical needs of patients for insurers.  Primary activities include:
    1.  Retail/Dispensing. They create networks of existing pharmacies to dispense drugs so that patients can get them, and in some cases, they manage mail order prescriptions. They negotiate with the retailer how much the retailer will receive for each prescription filled.
    2. They negotiate prices with manufacturers using volume to try and get the best discounts.
    3. They create formularies – deciding which drugs should and should not be covered. As noted, this can be because of cost, efficacy, reliability, safety and often based on the rebate money involved.

In the future, PBMs could take a different strategy.  Possible roles include:

  1. PBMs could take on risk. Instead of managing a pharmacy benefit for insurers, a PBM could take responsibility for the cost of pharmacy coverage for an insurer. If an insurer’s historical spend had been $1M for a population, the PBM could offer to assume that risk. They get paid $1M or maybe $900K. If they keep the costs lower than the amount they get paid, they win. If they don’t, then they lose.
  2. PBMs could take partial risk. PBMs could share risk with insurers. If costs are below some pre-determined amount, they share the good fortune. If costs are above, they share the pain.
  3. PBMs could work on performance guarantees. These guarantees could be based on a combination of cost, service levels (customer satisfaction), and clinical quality based on an audit.

How does this affect me as an employer?

While the current rule is focused on Medicare and Medicaid, many experts see this as the beginning with an extension to commercial markets further down the road. It’s important to start paying attention to this issue now before it arrives on your doorstep.

When it comes to drug rebates, not all employers are in the same position. While there are nuances, for the most part, employers can be grouped into two categories.

  1. Fully Insured. Fully insured employers buy insurance from a carrier like Blue Cross Blue Shield, UnitedHealthcare, or UPMC Health Plan. This means the insurer assumes all of the risk for the medical costs incurred by the employees. In this case, the rebates go to the insurer or are shared between the insurer and the PBM. The insurer has the freedom to use the rebate money to increase profit margin or subsidize the premium cost. In most cases they probably do a little bit of both, but the allocation is their choice.
  2. Self-Insured. In this case, the employer is the insurer (though they typically don’t administer the benefits themselves). This means they assume the risk and, in most cases, get the benefit of the rebates. The extent to which they benefit from the rebates depends on their contract with their PBM.

If an employer is in the former group, the elimination of rebates is likely to result in more transparency in pricing. There are a number of technical indicators that can be used to help understand how an employer’s premium dollar is being spent such as Medical Loss Ratio and Actuarial Value. Both of these indicators are thrown off by rebates. Elimination of rebates makes the “instrumentation” of these indicators more accurate. This means that employers can make more reasoned and rational choices about their coverage.

If an employer is in the latter group, the situation is a bit different. Employers directly benefit from rebates when they are self-insured. Their employees often may end up paying more (for the reasons stated in this article and the previous), but the employer essentially gets cash back on the back-end and it is not clear what the employer must do with it. Different employers probably treat these funds differently. Some employers may appreciate the freedom afforded by the funds from the rebate, while many may be unaware that they may not be receiving the full potential of the rebate.

Of course, this simplifies the scenarios. Different arrangements may occur, such as with pharmacy coalitions which pull the buying power of many employers to negotiate lower cost of drugs and increased pass through of rebates, or with self-insured health insurance coalitions or associations. The degree of impact to employers in these arrangements will vary depending on the specifics of the arrangement.


Self-insured and fully insured employers have different interests with respect to rebates. Two things, however, are clear.

  1. Regardless of fully vs self-insured, it is unlikely the employer is getting the full benefit of the rebates. Elimination of rebates is likely to increase transparency of the economic relationships but the transparency may be short lived. The industry will understandably zealously guard the secrecy of its business practices and create new methods of making the payments between parties opaque.
  2. Employees do not benefit from rebates as currently administered. Rebates inflate retail prices and retail prices determine patient copayments and coinsurance levels.

With Medicare and Medicaid being the guinea pigs for this new ruling, it will be interesting to see how the markets evolve and modify the money flow to continue bringing in the profits. That’s not to say the rule won’t work, but big business or big pharma will certainly aggressively try and find creative ways to keep the drug money flowing. In addition, you (in the commercial markets) may end up taking the burden of drug cost shifting from government regulated plans (Medicare and Medicaid), assuming the rule isn’t extended to all markets. Pay close attention to what unfolds over these next six months because the industry changes will likely impact you one way or another.

Please give us your Feedback.

Tonic Advisors and the Pittsburgh Business Group on Health will continue to keep you updated on this important issue. We would love to start a virtual conversation in the Comments Section below. Please add your thoughts or questions.


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