DEPARTMENT OF HEALTH &. HUMAN SERVICES 	 Office of Inspector General 
Washington, D.C.  20201 
NOV 172010 
TO: 	 Donald M. Berwick, M.D. 
Administrator 
Centers for Medicare & Medicaid Services 
FROM:  Stuart Wright 
Deputy Inspector General 
for Evaluation and Inspections 
SUBJECT: 	 Memorandum Report:  Medicare Part D Pharmacy Discounts for 2008, 
OEI-02-10-00120 
This memorandum report provides information about how sponsors negotiate discounts with 
pharmacies, how these discounts differ among brand-name and generic drugs, and whether 
sponsors are passing these discounts on to beneficiaries and the Government.  Prior to this 
review, little information was available about pharmacy discounts.  This information is critical 
for the Part D program because these discounts directly affect the amount that beneficiaries and 
the Government pay for Part D drugs. 
We found that for all six sponsors we reviewed, pharmacy benefit managers (PBM) negotiated 
lower drug prices with pharmacies in exchange for the pharmacies being in the sponsors' 
networks.  We also found that the pharmacy discounts for brand-name drugs were based on 
average wholesale prices, whereas the discounts for generic drugs were based on prices 
established by PBMs.  Finally, we found that for five ofthe six sponsors, pharmacy discounts 
were not always passed on to beneficiaries and the Government.  These results provide valuable 
information about how PBMs negotiate with pharmacies for lower Part D drug prices and about 
the pricing methods sponsors use to pay for these drugs.  These results further highlight the 
importance of sponsors ensuring that they are receiving the pharmacy discounts they negotiated 
and that they are passing these discounts on to beneficiaries and the Government. 
OEI-02-10-00120  Medicare Part D Pharmacy Discounts for 2008   
Page 2  Donald M. Berwick, M.D. 
 
 
 
BACKGROUND 
The Medicare Prescription Drug Benefit 
The Medicare prescription drug program, known as Medicare Part D, provides an optional drug 
benefit to Medicare beneficiaries.1  The Centers for Medicare & Medicaid Services (CMS) 
contracts with private insurance companies, known as Part D sponsors, to provide the drug 
benefit to beneficiaries who choose to enroll in the program.  
 
Under Medicare Part D, sponsors may offer stand-alone prescription drug plans or they may 
offer prescription drug coverage as part of a managed care plan.  At a minimum, Part D sponsors 
are required to offer a basic prescription drug benefit that is either the standard prescription drug 
benefit or is actuarially equivalent to the standard benefit.2  Most beneficiaries are responsible 
for certain costs, which may include a monthly premium, an annual deductible, and coinsurance 
or copayments.  However, low-income beneficiaries are eligible to receive assistance to pay 
some or all of these costs.3 
 
Pharmacy Discounts  
CMS requires that Part D sponsors develop a network of pharmacies to dispense drugs to 
beneficiaries enrolled in their plans.4  Sponsors generally contract with third-party entities, 
known as PBMs, to develop their pharmacy networks.5  CMS requires these pharmacy networks 
to be geographically diverse and to include different types of pharmacies, such as retail 
pharmacies and long-term care pharmacies.6  
 
Sponsors also contract with PBMs to negotiate discounts with pharmacies.  These pharmacy 
discounts affect the prices that beneficiaries and the Government pay for Part D drugs.  In 
addition to negotiating lower drug prices with network pharmacies, PBMs also negotiate 
dispensing fees, which are payments provided to pharmacies for each drug dispensed.   
 
It is important to note that pharmacy discounts are distinct from drug manufacturer rebates.  
Discounts negotiated with pharmacies are typically reflected in the price that the beneficiary 
pays at the pharmacy, whereas rebates are typically lump-sum payments made by drug 
manufacturers to sponsors.  Drug manufacturers provide rebates to sponsors when they 
encourage beneficiaries to use certain drugs.   
 
 
1 The Medicare Prescription Drug, Improvement, and Modernization Act of 2003, P.L. 108-173. 
2 42 U.S.C.  1395w-102, 42 CFR  423.104(d) and (e).  Actuarially equivalent means that the plans benefits must be of a 
dollar value equivalent to that of the standard benefit. 
3 42 CFR  423.780 and 423.782. 
4 42 U.S.C.  1395w-104(b)(1), 42 CFR  423.120(a). 
5 PBMs can provide a number of services to sponsors, including processing prescription drug claims, contracting with 
pharmacies, and managing formularies.  Sponsors may also perform these services themselves.   
6 Long-term care pharmacies provide specialized services, such as a comprehensive inventory of drugs commonly used in  
long-term care settings, specialized packaging, 7-day-a-week delivery, and emergency medications.   
OEI-02-10-00120    Medicare Part D Pharmacy Discounts for 2008        
Page 3  Donald M. Berwick, M.D. 
 
 
Payment to Pharmacies for Part D drugs  
PBMs pay the pharmacies for drugs on behalf of the sponsors, and the sponsors later reimburse 
the PBMs for those drugs.  The amount that the sponsor pays the PBM varies depending upon 
the pricing approach.  Sponsors may contract with the PBM using what is known as lock-in 
pricing or pass-through pricing.  
 
When lock-in pricing is used, the sponsor pays the PBM a set amount for its drugs.  The PBM 
then negotiates with pharmacies for the best possible price, which may vary from the price the 
sponsor agrees to pay the PBM.   If the PBM negotiates a lower price for a drug, then the PBM 
keeps the difference between the price the sponsor agreed to pay and the amount that the PBM 
actually pays the pharmacy.  Conversely, when pass-through pricing is used, the sponsor 
reimburses the PBM the same amount that the PBM pays the pharmacy.  The pass-through price 
is often lower than the lock-in price.7  
 
METHODOLOGY 
 
This memorandum report describes pharmacy discounts in the 2008 plan year.  It is based on a 
review of contracts from six selected sponsors and their PBMs and structured interviews with 
officials from these six selected sponsors and their PBMs.   
 
We selected a purposive sample of six Part D sponsors based on the number of beneficiaries 
enrolled in their plans and the PBMs they contracted with to get a variety of sponsors and PBMs 
for our review.8  Each of the six sponsors contracted with at least one PBM.  These six sponsors 
represented more than 25 percent of all Part D beneficiaries in 2008.  These are the same six 
sponsors that we reviewed in a forthcoming report entitled Concerns With Rebates in the 
Medicare Part D Program.9   
 
Review of Contracts 
For each of these 6 sponsors, we selected a purposive sample of 10 contracts that the PBM had 
with network pharmacies.  To select these contracts, we first requested a list from each sponsor 
of all of the contracts it or its PBM had with pharmacies in 2008.  From these lists, we selected 
10 contracts from each sponsor.  We selected a mix of contracts that covered retail and long-term 
care pharmacies as well as chain and independent pharmacies.  In total, we received and 
reviewed 60 contracts.  We reviewed these contracts for information about the nature and extent 
of pharmacy discounts and any associated dispensing fees.   
  
 
7 The lock-in price includes a risk premium which the sponsor pays to the PBM to mitigate market risk and shield the  
Part D sponsor from price variability between pharmacies.  74 Fed. Reg. 1494, 1505 (Jan. 12, 2009).  Beginning  
January 1, 2010, CMS required Part D sponsors to use the price received by the pharmacy to calculate beneficiary cost 
sharing and total drug costs.  74 Fed. Reg. 1506, 1544 (Jan. 12, 2009).  
8 These six sponsors were selected from a universe of 258 Part D sponsors. 
9 Office of Inspector General, Concerns With Rebates in the Medicare Part D Program, OEI-02-08-00500, forthcoming. 
OEI-02-10-00120    Medicare Part D Pharmacy Discounts for 2008        
Page 4  Donald M. Berwick, M.D. 
 
 
We also requested and reviewed all of the contracts that the six selected sponsors had with PBMs 
in 2008.10  We reviewed these contracts to determine the nature of the contractual relationships 
between the sponsors and their PBMs and how discounts were passed on to beneficiaries and the 
Government.  
 
Structured Interviews 
We conducted structured in-person or telephone interviews with officials from each of the six 
selected sponsors.  We interviewed these officials to gain a better understanding of their 
pharmacy networks and discounts and their contractual relationships with PBMs.  We requested 
that representatives from the PBM also be included in the interviews.  In some cases, the 
representatives from the PBMs requested that we speak to them without the sponsors present 
because of the confidential nature of the information.  
 
Our questions focused on how discounts were negotiated with pharmacies, the size of their 
pharmacy networks, the nature and extent of pharmacy discounts, and any associated dispensing 
fees.  We also asked questions about the contractual relationships between the sponsors and their 
PBMs.  For some questions, such as how discounts were negotiated with pharmacies, PBMs 
answered on behalf of the sponsors.  Our questions focused on the 2008 plan year.  We 
conducted these interviews between December 2008 and April 2009. 
 
Limitations 
The information in this memorandum report is from six selected sponsors and is not 
generalizable to all sponsors.  In addition, because of the proprietary nature of the data on 
discounts, we presented general information and did not include specific data for the individual 
sponsors.  
 
Standards 
This study was conducted in accordance with the Quality Standards for Inspections approved by 
the Council of the Inspectors General on Integrity and Efficiency.  
 
RESULTS 
 
For All Six Sponsors, PBMs Negotiated Lower Drug Prices With Pharmacies in Exchange 
for the Pharmacies Being in the Sponsors Networks 
Each of the six sponsors we reviewed relied on PBMs to negotiate drug prices with pharmacies.  
These negotiations resulted in pharmacies charging lower drug prices for Part D beneficiaries 
than the prices they would charge their cash-paying customers.  Pharmacies generally accepted 
these lower prices because participating in sponsors networks increased the number of 
beneficiaries who used their pharmacies.  Each of the 6 sponsors reported that their pharmacy 
network consisted of at least 55,000 pharmacies; 1 sponsor had more than 63,000 network 
pharmacies.   
 
10 In total, the six sponsors had nine contracts with PBMs.  Two of the sponsors had contracts with more than one PBM. 
OEI-02-10-00120    Medicare Part D Pharmacy Discounts for 2008        
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The PBMs for the six selected sponsors reported that they prepare standard contracts for various 
types of pharmacies, such as retail pharmacies and long-term care pharmacies.  These contracts 
dictated the discounts that pharmacies had to accept in order to be part of the sponsors network.  
Several PBMs reported that it was rare for pharmacies to participate in their networks if the 
pharmacies refused to accept the discounts in these standard contracts.  However, in some cases, 
the PBM was willing to negotiate smaller discounts if, for example, the PBM needed a particular 
pharmacy to ensure sufficient geographic coverage in the pharmacy network.11  
 
For All Six Sponsors, Pharmacy Discounts for Brand-Name Drugs Were Based on Average 
Wholesale Prices and Varied by the Length of Supply, Pharmacy Type, and Geographic 
Location 
For brand-name drugs, PBMs negotiated discounts based upon a fixed percentage that is 
subtracted from the drugs average wholesale price (AWP).12   In the contracts we reviewed, this 
percentage is applied to all brand-name Part D drugs and varied by several factors, including the 
length of the supply, the pharmacy type, and geographic location.   
 
Notably, in the contracts we reviewed, different discounts were often provided to retail 
pharmacies for an extended supply of drugs, such as a 3-month supply, versus a short-term 
supply of drugs.13  When this occurred, the discounts for an extended supply were greater and 
generally ranged from 18 percent to 22 percent of AWP.  This compares to 15 percent to  
17 percent of AWP for a short-term supply of drugs.  In addition, these contracts often 
established higher dispensing fees for an extended supply of drugs.  The average dispensing fee 
for an extended supply was $2.20, compared to an average of $1.90 for a short-term supply. 
 
In a number of contracts, the pharmacy was given a separate option to participate in the 
sponsors network for providing extended supplies of drugs.  In these cases, the discounts for 
providing extended supplies were highfor example, 23 percent of AWPand there was often 
no dispensing fees provided to the pharmacy.  Only 9 of the 16 pharmacies that were offered this 
option chose to participate in the sponsors extended supply network.   
 
Further, discounts for drugs dispensed by long-term care pharmacies were generally smaller than 
those for drugs dispensed by retail pharmacies.  In the contracts we reviewed, the discounts for 
drugs dispensed by long-term care pharmacies generally ranged from 12 percent to 14 percent, 
compared to 15 percent to 17 percent for retail pharmacies.  In addition, long-term care 
pharmacies generally received higher dispensing fees.  For example, in one contract we 
 
11 Sponsors must include enough pharmacies in their network to ensure that all beneficiaries have convenient access.   
42 CFR  423.120.  
12 The contracts also specified that PBMs would not pay the pharmacies more than the prices that they charge their  
cash-paying customers.  As one contract noted, AWP does not represent a true wholesale price, but rather is a fluctuating 
benchmark.  Therefore, it is possible for the discounted prices to exceed the standard prices paid by cash-paying customers.  
This provision of the contract, commonly called a usual and customary provision, ensures that the PBM pays the lesser of the 
cash price or the discount based on AWP. 
13  The length of supply could be either a short-term supply or an extended supply.  The number of days included in a 
 short-term supply was generally 1 month or less.  An extended supply was generally more than 1 month and up to 3 months.   
OEI-02-10-00120    Medicare Part D Pharmacy Discounts for 2008        
Page 6  Donald M. Berwick, M.D. 
 
 
reviewed, long-term care pharmacies received dispensing fees that were twice as much as the 
dispensing fees provided to retail pharmacies. 
 
Discounts also sometimes differed for certain geographic locations.  For example, five of the six 
selected sponsors reported that their discounts were less substantial in certain areas, such as 
Alaska, Hawaii, the U.S. Virgin Islands, and Puerto Rico.  One contract we reviewed for a 
pharmacy in Alaska set the discount at 5 percent of AWP.  This contract also included a 
dispensing fee of almost $8.  One sponsor noted that these pharmacies often have higher costs 
because of their remote locations.   
 
For All Six Sponsors, Pharmacy Discounts for Generic Drugs Were Based on Prices 
Established by PBMs and Were Often Accompanied by Higher Dispensing Fees and 
Benchmarks To Encourage Generic Drug Use 
Pharmacy discounts for generic drugs were negotiated differently than the discounts for  
brand-name drugs.  For each of the six selected sponsors, the PBM developed a list of generic 
drugsknown as the Maximum Allowable Cost (MAC) listwhich established a maximum 
amount that the sponsor will pay for each drug on this list.14   
 
Several PBMs noted that prices on their MAC lists change frequently, sometimes on a weekly or 
even a daily basis.  PBMs also noted that pharmacies were not routinely provided access to the 
MAC lists.  Most PBMs in our review provided their MAC lists (or a portion of their MAC list) 
to pharmacies only under limited circumstances, and one PBM would not share its MAC list 
under any circumstances.   The pharmacies agreed to accept the prices on the MAC list without 
knowing what these prices were until they submitted their claims.   
 
Further, in the contracts we reviewed, PBMs often established larger dispensing fees for generic 
drugs to encourage generic drug use.  These fees were an average of 30 cents higher than the 
dispensing fees for brand-name drugs.  Several of the contracts also allowed for additional 
payments to be made to the pharmacy if the pharmacy achieved certain levels of generic drug use 
among its Part D beneficiaries. 
 
In addition, several sponsors contracts included benchmarks that must be met by their PBMs.  
These benchmarkswhich are often called generic effective ratesrequired the PBM to provide 
a minimum average discount among its network pharmacies for generic drugs.  For example, one 
contract specified that average generic drug prices not exceed the AWP less 62 percent.  If the 
discounts negotiated by the PBM did not meet this benchmark, the PBM had to reimburse the 
sponsor the difference.  These benchmarks help to encourage generic drug use among Part D 
beneficiaries.   
 
 
14 For generic drugs not included on the MAC list, the contracts specified that the sponsor would receive a discount based on 
the drugs AWP.  The contracts also specified that the sponsor would not pay the pharmacy more than the prices they charge 
their cash-paying customers.   
OEI-02-10-00120    Medicare Part D Pharmacy Discounts for 2008        
Page 7  Donald M. Berwick, M.D. 
 
 
For Five of the Six Sponsors, Pharmacy Discounts Were Not Always Passed on to 
Beneficiaries and the Government 
Five of the six selected sponsors reported using lock-in pricing for at least some drugs in 2008.  
In some cases, sponsors used lock-in pricing for some plans and not for others.  In other cases, 
they used lock-in pricing only for certain types of drugs, such as generic drugs.  
 
When lock-in pricing was used, beneficiaries and the Government did not always receive the full 
benefit of the pharmacy discounts negotiated by PBMs.  This was because the lock-in prices
rather than the actual pharmacy discounts negotiated by PBMswere used to calculate both the 
beneficiaries and the Governments share of the drug costs.  Because lock-in prices tend to be 
higher than the actual pharmacy discounts negotiated by PBMs, this pricing method increases the 
overall cost of these drugs for beneficiaries and the Government.15  
 
Beginning in 2010, CMS required sponsors to provide the full benefit of pharmacy discounts to 
beneficiaries and the Government.  CMS issued new regulations requiring sponsors that use 
lock-in pricing to include all pharmacy discounts negotiated by PBMs to calculate beneficiaries 
and the Governments share of the drug costs.16   
 
CONCLUSION 
 
Pharmacy discounts are an effective tool for lowering the costs of Part D drugs.  We found that 
for all six sponsors we reviewed, PBMs negotiated lower drug prices with pharmacies in 
exchange for the pharmacies being in the sponsors networks.  We also found that the pharmacy 
discounts for brand-name drugs were based on average wholesale prices, whereas the discounts 
for generic drugs were based on prices established by PBMs.  Finally, we found that for five of 
the six sponsors, pharmacy discounts were not always passed on to beneficiaries and the 
Government.  These results provide valuable information about how PBMs negotiate with 
pharmacies for lower Part D drug prices and about the pricing methods sponsors use to pay for 
these drugs.  These results further highlight the importance of sponsors ensuring that they are 
receiving the pharmacy discounts they negotiated and that they are passing these discounts on to 
beneficiaries and the Government.   
 
This report is being issued directly in final form because it contains no recommendations.  If you 
have comments or questions about this report, please provide them within 60 days.  Please refer 
to report number OEI-02-10-00120 in all correspondence. 
 
 
15 74 Fed. Reg. 1505, 1544 (Jan. 12, 2009). 
16  42 CFR  423.100, 74 Fed. Reg. 1544 (Jan. 12, 2009).  See also 74 Fed. Reg. 15051506 (Jan. 12, 2009). 
OEI-02-10-00120    Medicare Part D Pharmacy Discounts for 2008