No Free Lunch…Except in Pharma

How Prescription Drug Rebates Work … But Don’t “Work” for YOU

By Vik Mangalmurti and Randy Main, Tonic Advisors

Have you ever gone to a restaurant with a friend and split the bill?  You go, order a meal, talk, and when the check comes your friend says “let me put it on my card, and you can just give me half in cash.  It will save me a trip to the ATM anyway.”  It’s a normal enough interaction and if the total bill plus tip was $40, you fork over a $20 for your share.  In some respects, this is the way standard copay and co-insurance models are intended to work at a doctor’s office or for a hospital stay.  The bill comes, it’s for $1,000, your coinsurance is 20%, so you pay $200 and the insurance (your friend) covers the rest.  This is how health insurance works…most of the time.  It’s just that this isn’t the way it works in the pharmaceutical industry.

Most people probably think that the pharmaceutical industry should work something like the diagram below.

How We May Think the Rx Industry Works

This is the way we buy most goods and services.  Someone makes them in bulk, sells them to a distributor and then the distributor sells them to retailers and the retailer sells them to us.  We assume that the insurance that pays for our prescriptions works similarly.  Most of us think that the difference is that we split the cost with the insurance company when we buy, or that we split the insurance company’s discounted rate. Actually, it often doesn’t work this way.

Instead, you go to the restaurant with your friend, order lunch, and your friend pulls out his credit card.  You pay him $20 for your half.  Your friend pays the $40 tab.  What you don’t know is that your friend’s credit card has a deal with the restaurant.  The restaurant sends 25% of the total tab back as a credit to your friend’s credit card.  In the end, you pay $20 bucks for lunch and your friend paid $10.  That’s a lot closer to the way it actually works in the pharmaceutical industry.

How the Rx Industry Really Works


In the middle of these transactions sits a Pharmacy Benefits Manager (PBM).  The PBM helps insurance companies choose formularies (the lists of drugs the insurer will pay for) based on multiple factors.  Some of these factors are clinical (Drug A is better than Drug B at treating a disease).  Some of these factors are based on very standard cost concerns (Drug A and B are equally effective, but one costs less than the other).  And some are based on undisclosed discounts and rebates, e.g., if the PBM gets to a volume of X on Drug A, the PBM will get 25% of the costs back as a rebate, which can be shared with the insurer.

The Problem


Above board discounts and rebates would not cause problems.  Let’s say your friend had a coupon for $10 off when you bought two entrees.  The price of the lunch would go from $40 to $30, and you would each pay $15.  With the undisclosed rebate, however, you don’t get the benefit of the discount or rebate.  All of the benefit goes to your friend (Your friend pays $10, you pay $20).

In most cases when you have insurance, you have an agreement to cover part of the costs, e.g., copay or coinsurance. The insurer covers the rest. Because you really don’t know what the net cost is to the insurer, you may be actually covering more than the amount you agreed on.  When there is a copay and the cost of the drug is low, you may be paying more than the actual cost of the drug to the insurer in the first place.

In an extreme example, you could pay a $10 copay on a drug that “costs” $15 but where the insurer gets a rebate of $7 (making the actual net cost only $8).  You are out $10, the pharmacist gets that $10 you paid plus an extra $5 from the insurer (total $15), but the insurer gets back $7 thus profiting $2.


The Trump administration seeks to limit use of such rebate agreements.  The impetus is that current agreements often do not result in sound prescribing practices or fair market tactics and competition.  Such agreements can induce insurers to put more costly drugs on formulary.  After rebates and copays, the cost of some brand name drugs –to the insurer— can be lower than generic alternatives.  The patient on the other hand may end up paying more.

The equivalent is your friend recommending going to the restaurant where his credit card gives him or her the rebate, even if the food is worse and more expensive.  After the rebate, it is almost free for your friend.  You, however, are stuck with a big tab, bad food, and an even worse taste in your mouth.

There are likely to be many on the left (or in the party that begins with D) who don’t care for this change in policy because it comes from an administration that begins with “T”.  We do not suggest that the changes proposed are perfect. More specific implementation plans would be helpful for analysis.  We only urge critical analysis of the proposal on the merits of the proposal itself and its goals rather than its political source.  The proposal is a solid start towards increasing transparency in drug pricing.

Please give us feedback

We know we have oversimplified.  There are nuances and complexities we did not delve into; but we did so because we didn’t want to lose sight of our main purpose.  We believe we captured the gist of the dynamics of product (medicine), money, and information flow in the pharmaceutical industry.  As specifics become clear about the proposals, we will update.  As points are made in response to this article, we will respond so that we can keep the discussion going.  We look forward to a virtual dialog with the readership.

Comments (14)

  1. Rory

    How much money are we talking about in total nationwide? Is this a big source of escalating healthcare prices or pretty minimal?

    • Vik Mangalmurti

      Hi Rory, thanks for the question. I have seen estimates published in Health Affairs based on data by Altarum that the rebates in 2016 were around $89 Billion. Given overall medical inflation I would guess that they are currently between $95-$100 Billion today. this is about 3% of the total healthcare cost of the U.S. Rebates are not a cost per se–they don’t directly add to overall expenditures. They are just a classification of how some money changes hands. The issue with rebates is that they are big enough to create a powerful incentive to behave in one way as opposed to another. If that incentive generates useful results (for example drives higher quality medical outcomes), then few people would be concerned. The fear is that they may at times generate unfavorable outcomes or needlessly higher costs. Understanding how much this contributes to the cost of healthcare depends on a different calculation. It would be interesting to see a study that demonstrated to total overall inefficiency in drug prescribing and filling based on A) use of brand name drugs when suitable generics were available, + B) use of less effective or generally more costly drugs in place of more effective or less costly drugs and C) an analysis of what portion of A + B are driven by rebating incentives as opposed to poor training or knowledge of available alternatives.

  2. Jeff

    Isn’t the HHS rebate proposal specific to Medicare and Medicaid only? I saw some news regarding a senate bill that would expand this to Commercial markets as well. Should all markets be treated equal?

    • Vik Mangalmurti

      Hi Jeff, yes absent some congressional legislation, the proposal is limited to federal programs. It is worth noting though that the rebates are a bigger portion of the total cost in Medicare Part D (Prescription drug program) and Medicaid than in commercial. It is also worth noting that policies that the federal government puts in place have a tendency to trickle down. Certainly congress can mandate greater transparency should it choose to act.

  3. Gents: as I mentioned on LinkedIn, the specter of the consumer paying more in a copayment or coinsurance than the actual cost of the drug to the insurer is indeed troubling. A 3/13/18 JAMA article illustrates your contention quite well and provides a highly detailed analysis of the frequency and magnitude of the overpayments. Perhaps later on in your series you could delve into the impact of what a monopsony like Medicare is having on overall cost and drug supplies. Looking forward to reading the next article in your series!

    • Vik Mangalmurti

      Thanks Dan. The effect of leveraging the massive buying power from federal programs (Medicare, Medicaid, VA, IHS etc.) on drug prices is an interesting topic and one that we will look into as we see more discussion of changing health coverage options (universal health care, Medicare for all, Medicare Advantage for all, expanded Medicaid etc.) going in to the next election cycle. For those interested in the article Dan referenced, here is a link to the abstract.

  4. David Daniel Jangam

    Thanks Vik and Randy! This article succinctly explains the dynamics of cost sharing between the member and the insurer. The key enlightening aspect from the article is that pricing to the member does not capture the discounts and rebates received by the insurer. It is interesting to know that pharmacy benefits are in principle not cost sharing even though they are marketed as one.

    Does this mean that in most cases insurer makes a profit from these discounts form PBMs/middle men without a spending a $ premium amount? Or are they spending a marginal amount out of premium amounts and still making profit?

    Look forward to your insights.

    • Vik Mangalmurti

      Hi David,

      just to clarify. As we understand it, the pharmacy benefits do factor into the cost sharing. As such they are part of the Actuarial Value and MLR calculations. We have not been able to get a definitive answer on how rebates factor into those calculations. I believe most carriers would say that the value of the rebates is that they are used to defray the overall cost of the premium. That is to say the rebates are used to keep total costs down. I am not certain as of this writing whether carriers use the rebates to reduce Administrative Costs or Medical Costs, and it is not clear to us if there is a requirement that they do one or the other. If anyone reading these comments is aware of the way that Actuaries are required to treat rebates, it would be great to see that posted.

  5. I really enjoyed this article! Here is my opinion and I have worked with PBM’s for the last 12 years. First off there are a lot of problems, rebates have created issues in the market. However, drug prices have also created a major issue in the market. Big pharma is real quick to point the finger at PBM’s and say it is their fault for forcing us to pay all these extremely high rebates. But here is what they don’t tell you. When negotiating those rebates Big Pharma tells the PBM “I want you to only cover this drug for this therapeutic class. If you put another alternative on there we will lower all your rebates!” I work for a PBM that was a startup back in 2011, when we first started we didn’t have a rebate contract in place yet, and guess how much big pharma cut their costs by? $0. There were absolutely zero savings for the PBM or our clients when we didn’t ask for rebates. Now that we have a rebate contract we pass 100% of the third party revenue back to the employer. We run a true transparent pass through that is real and shows the true costs. The solution everyone is asking for is already in place with PBM’s like mine we are voluntarily offering the savings back to companies because we believe it is the right thing to do. Let’s stop asking Washington for bigger government and let’s start sending business to the companies that are real difference makers. If you want to learn more about the tricks the BIG PBM’s play email me at joshua.harvey@phoenixpbm I will be happy to share them with you.

    • Vik Mangalmurti

      Hi Josh, thanks for your comment. It is an interesting issue and I know that there are some PBMs that will, per your company, pass 100% of the rebate back to the carrier and depending on the arrangement, back to the self insured employer. Some analyses have suggested that costs could actually rise as a result of the end of rebates as “big Pharma” and wholesalers will not pass on the equivalent amount in discounts that are currently provided in rebates. I think that there are a couple of issues that are worth exploring, in coming analytics. The first is the general issue of transparency to the member purchasing at the retail level–they are unaware of the larger financial picture. In fact, it is not even clear how rebates currently factor into MLR and Actuarial Values. The second is that the rebates– because of their hidden nature — can cause misaligned incentives between PBMs, Wholesalers, Carriers, and Members (you and me who get prescriptions filled at a pharmacy). We could end up purchasing unnecessarily expensive medicines in lieu of more effective/ less costly ones. While many carriers use the rebates to subsidize rates, others use them to offset Administrative cost, which leaves more room for profit. Carrier leeway in using the rebate funds (even when applied to Medical Costs (MLR)) means that they are not necessarily allocated back to the patient populations that generated the funds/costs. Heavy pharma users can effectively end up subsidizing non-pharma users. In any case it is a complicated issue and we appreciate your thoughts. The more discussion we can generate the more well informed we will all become.

  6. Amber Malek

    This is only one part of the problem. The pharmacutical companies are then offering additional rebates to the patients themselves and they aren’t even paying the co-pays. They are offering $20,000 debit cards to the consumer because the medication costs $15,000 a month. As a self-funded plan, the company is out of all of that money. The employee enrolls in the high deductible plan- first month, they have met the family deductible and now the entire family pays nothing out of pocket for the whole year. They can do this for 4 years.

    Most of my employees on speciality drugs, have additional coverage through the pharmecutical manufacturer and pay little to nothing of their actual bill or co-pay. It’s great for my employees but if pharma didn’t charge such ridiculous amounts of money, the rebates and co-pay subsidies wouldn’t be needed. The whole process needs a serious overhaul. These are life saving drugs and are very necessary. It is absurd that the process works the way that it does.

  7. Stephen J Gaus

    I had this very thing happen to me on a topical crème that was prescribed by my Dermatologist. He said he’d order the crème and it would not cost me anything and come mailorder. Two days later I got a call from the specialty pharmacy telling me there was a $675 co-pay. I told the agent that wasn’t free and did she have any coupons to bring the price down? she said yes I have some coupons that would reduce the co-pay to $425 and did I want to proceed. I replied that is still not FREE and was there anything else she could do to reduce the price? she replied yes now that you have asked if we don’t use your insurance and I use the coupons I can get it down to $40 co-pay…would you like to proceed?
    Had I not asked they were going to bilk me and or my Health Plan for an extra $635 or $425…this action by the Administration just might prove to be the best thing they have done for Americans!

    • Vik Mangalmurti

      Hi Stephen, thanks for your response. The numbers you mentioned are pretty startling. Not knowing the specifics its hard to make more precise analysis or comment, but the issue that is most striking is the convolutedness of the system. By saying the magic code words, the price drops.

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