DEPARTMENT OF HEALTH & HUMAN SERVICES 
Centers for Medicare & Medicaid Services 
7500 Security Boulevard, Mail Stop S2-26-12 
Baltimore, Maryland 21244-1850 
 
Center for Medicaid and State Operations 
 
                    SMDL #02-014   
 
            September 18, 2002 
 
 
 
Dear State Medicaid Director: 
 
This letter is to clarify issues related to supplemental drug rebate agreements and prior 
authorization of Medicaid covered outpatient drugs.  A number of States have sought 
CMS approval of supplemental drug rebate agreements between a State and drug 
manufacturers with respect to Medicaid covered outpatient prescription drugs.  Some of 
these States subject covered outpatient drugs to prior authorization as a means of 
encouraging drug manufacturers to enter into separate or supplemental rebate agreements 
for covered drugs purchased by Medicaid recipients. 
 
Medicaid Supplemental Drug Rebate Agreements 
 
States may enter separate or supplemental drug rebate agreements as long as such 
agreements achieve drug rebates equal to or greater than the drug rebates set forth in the 
Secretarys national rebate agreement with drug manufacturers, which is published at 56 
F.R. 7049 (1991).  The drug rebate statute, at section 1927(a)(1) of the Social Security 
Act (Act), provides that the Secretary may authorize a State to enter directly into 
agreements with a manufacturer.  Also, section 1927(a)(4) of the Act provides that any 
drug rebate agreement between a State and drug manufacturers and in effect on 
November 5, 1990, may constitute a rebate agreement in compliance with the statute if 
CMS determines that any such agreement provides for rebates that are at least as large 
as the rebates otherwise required under this section.  CMS accordingly believes that 
Congress intended that States that seek CMS approval under section 1927(a)(1) to enter 
directly into agreements with manufacturers must ensure that any such agreement will 
achieve drug rebates that are at least equal to the rebates set forth in the Secretarys rebate 
agreements with manufacturers. 
 
We remind States that supplemental drug rebates must be considered to be a reduction in 
the amount expended under the State plan in the quarter for medical assistance as 
required by section 1927(b)(1)(B) of the  Act.  
 
 
  Page 2  State Medicaid Director 
 
Prior Authorization Requirements Related to Supplemental Rebate Agreements 
 
States may subject covered outpatient prescription drugs to prior authorization as a means 
of encouraging drug manufacturers to enter into separate or supplemental rebate 
agreements for covered drugs purchased by Medicaid recipients.  Section 1927(d)(1)(A) 
of the Act permits States to subject any covered outpatient drug to a requirement of prior 
authorization as long as the State complies with the requirements set forth in section 
1927(d)(5).  A prior authorization program used to negotiate drug discounts for the 
Medicaid program is consistent with those provisions as well as the paramount purpose 
of the drug rebate provisions which is to reduce the costs to the Medicaid program for 
prescription drugs. 
 
A prior authorization program does not need to comply with the requirements for 
restrictive formularies.  The formulary provisions of section 1927(d)(4) were added to the 
drug rebate provisions in 1993 to give States additional authority to implement restrictive 
formularies.  Congress passed paragraph (d)(4) expressly stating that [a] prior 
authorization program established by a State under [section 1927(d)(5)] is not a 
formulary subject to the requirements of this paragraph.*  Furthermore, since concerns 
related to drug use, monitoring, waste, fraud or abuse are separately and independently 
addressed by the procedures authorized by sections 1927(d)(6) and 1927(g), a prior 
authorization program need not be limited to those concerns.  The Act affords States 
broad authority and flexibility to implement a prior authorization program in order to 
secure cost savings for the Medicaid program. 
 
The operation of a prior authorization program used to negotiate drug discounts for the 
Medicaid population is a significant component of a State plan.  We would therefore 
expect that a State that does not currently have an approved prior authorization State plan 
amendment, and that seeks to undertake such a program, would submit to CMS for 
review a State plan amendment incorporating the programs prior authorization 
requirements, while simultaneously seeking CMSs authorization for its proposed 
separate or supplemental rebate agreement.  A State that has an approved State plan 
amendment governing prior authorization requirements, but which seeks for the first time 
to use its prior authorization authority to negotiate drug discounts for the Medicaid 
program, must amend its State plan to refer to the separate or supplemental rebate 
agreement and submit its proposed rebate agreement for CMS authorization.  
 
 
 
                                                 
*  Of course, the formulary provisions of section 1927(d)(4) continue to apply if a 
State chooses to make judgments about the therapeutic advantages of a drug excluded 
from a formulary, and the State plan must permit coverage of any such drug pursuant to a 
prior authorization program that complies with section 1927(d)(5).    Page 3  State Medicaid Director 
 
Non-Medicaid Supplemental Rebates and Medicaid Prior Authorization 
 
A number of States secure prescription drug benefits, rebates, or discounts for non-
Medicaid populations by linking such benefits to a Medicaid prior authorization program.  
The Act does not preclude States from negotiating prices, including manufacturer 
discounts and rebates for non-Medicaid drug purchases.  However, the establishment of a 
prior authorization program for Medicaid covered drugs to secure drug benefits, rebates, 
or discounts for non-Medicaid populations is a significant component of a State plan and 
we would therefore expect that a State would submit such a program for CMS review 
under the State plan process.  Similarly, the use of any pre-existing prior authorization 
program to secure drug benefits, rebates, or discounts for non-Medicaid populations 
would constitute a [m]aterial change[] in State law, . . . policy, or in the State's operation 
of the Medicaid program" and we would therefore expect that a State would submit a 
plan amendment to CMS for review.  (See section 430.12(c)(1)(ii) of the regulations.)  In 
submitting such a State plan amendment, the State should be prepared to demonstrate 
through appropriate evidence that the prior authorization program will further the goals 
and objectives of the Medicaid program.  A State could make such a demonstration by 
submitting appropriate evidence that its prior authorization requirement is designed to 
increase the efficiency and economy of the Medicaid program.  A State could 
demonstrate that its prior authorization requirement furthers Medicaid goals and 
objectives by submitting appropriate evidence that the requirement sufficiently benefits 
the Medicaid population as a whole by making available to financially needy individuals 
medically necessary prescription drugs, thereby improving their health status and making 
it less likely that they will become Medicaid eligible. 
 
If you have any questions regarding CMS policy relating to supplemental drug rebate 
agreements or prior authorization programs, please direct them to Larry Reed at (410) 
786-3325 or Deirdre Duzor at (410) 786-4626. 
 
              Sincerely, 
 
              /s/ 
 
Dennis G. Smith 
Director 
 
cc: 
 
CMS Regional Administrators 
 
CMS Associate Regional Administrators  
  for Medicaid and State Operations 
   
 
Page 4  State Medicaid Director 
 
Lee Partridge 
Director, Health Policy Unit 
American Public Human Services Association 
 
Joy Wilson 
Director, Health Committee 
National Conference of State Legislatures 
 
Matt Salo 
Director of Health Legislation 
National Governors Association 
 
Brent Ewig 
Senior Director, Access Policy 
Association of State and Territorial Health Officials 
 
Trudi Matthews 
Senior Health Policy Analyst 
Council of State Governments 
 
Jim Frogue 
Acting Director, Health and Human Services Task Force 
American Legislative Exchange Council