GAO

United States General Accounting Office

Report to Congressional Requesters

August 2000 PRESCRIPTION

DRUGS

Expanding Access to

Federal Prices Could

Cause Other Price

Changes

GAO/HEHS-00-118

Page 1 GAO/HEHS-00-118 Federal Drug Discounts

Contents

Letter 3

Tables Table 1: Pharmaceutical Pricing Terms 9

Table 2: Prices for Select Prescription Drugs Commonly Used by the

Elderly, February 2000 12

Abbreviations

AMP average manufacturer price

AWP average wholesale price

CBO Congressional Budget Office

DOD Department of Defense

FCP federal ceiling price

FSS federal supply schedule

GSA General Services Administration

HCFA Health Care Financing Administration

HMO health maintenance organization

HRSA Health Resources and Services Administration

OBRA Omnibus Budget Reconciliation Act of 1990

NFAMP nonfederal average manufacturer price

PHS Public Health Service

VA Department of Veterans Affairs
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United States General Accounting Office

Washington, D.C. 20548

Health, Education, and Human

Services Division

B-284570 Letr

August 7, 2000

The Honorable Tom Bliley

Chairman

Committee on Commerce

House of Representatives

The Honorable Michael Bilirakis

Chairman, Subcommittee on Health

and Environment

Committee on Commerce

House of Representatives

Federal departments and agencies can purchase prescription drugs at

substantial discounts off market prices through the federal supply schedule

(FSS) for pharmaceuticals. Administered by the Department of Veterans

Affairs (VA), the FSS for pharmaceuticals is a list of products and their

prices that are available to federal entities that purchase prescription

drugs.1 During fiscal year 1999, federal purchasers spent over $2.75 billion

on prescription drugs,2 about $1.5 billion of which was for drugs purchased

from the FSS. Also, federal law guarantees substantial drug price discounts

to state Medicaid programs and specific public health entities that receive

federal assistance.

As the Congress considers adding a prescription drug benefit to Medicare,

there is increased interest in understanding the ways that government

purchasers have controlled their costs for prescription drugs and whether

these methods can be used to reduce prescription drug costs for Medicare

beneficiaries. One proposal before the Congress would allow Medicare

beneficiaries to purchase drugs from pharmacies at the same prices that

are available to federal purchasers or state Medicaid programs. Because of

your interest in the issue of expanding Medicare beneficiaries’ access to

prescription drugs, you asked us to provide you with information on (1) the

federal drug price discounts available to federal and nonfederal purchasers

1 The FSS may list the same drug in different dosage amounts and package sizes. Each listing

is considered an individual item or product.

2 This total includes all FSS sales to federal purchasers, as well as non-FSS sales associated

with contracts VA and the Department of Defense (DOD) have with drug manufacturers.
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and the size of those discounts, and (2) the potential effects that extending

such discounts to nonfederal purchasers may have on outpatient drug

prices paid by federal and nonfederal purchasers.

To address these issues, we obtained information on the drug purchasing

methods and prices available to the federal departments and agencies that

spend the most on prescription drugs—VA, DOD, and the Public Health

Service (PHS). We also obtained information from the Health Care

Financing Administration (HCFA) on the rebates state Medicaid programs

receive through the Medicaid drug rebate program. In addition, we

contacted officials of the Health Resources and Services Administration’s

(HRSA) Office of Drug Pricing to determine the drug price discounts

available to public health entities that receive federal assistance.3 Further,

we reviewed several studies relevant to the potential impact of expanding

the availability of government drug price discounts to nonfederal

purchasers. We conducted our study between December 1999 and June

2000 in accordance with generally accepted government auditing

standards.

3

The Office of Drug Pricing is now called the Office of Pharmacy Affairs.
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Results in Brief Federal departments and agencies, state Medicaid programs, and

numerous nonfederal public health entities have access to prescription

drugs at substantially lower prices than many other purchasers. Federal

entities can purchase drugs from the FSS at prices that are the same or

lower than those drug manufacturers charge their most-favored private

purchasers. Under federal law, drug manufacturers must list their brandname drugs on the FSS to receive reimbursement for drugs covered by

Medicaid.4 Manufacturers must also sell brand-name drugs listed on the

FSS to four federal purchasers—VA, DOD, PHS, and the Coast Guard—at a

price at least 24 percent lower than the nonfederal average manufacturer

price (NFAMP), a ceiling price that is lower than the FSS price for many

drugs.5 In addition, VA has obtained some drug prices that are even lower

than FSS prices through national contracts based on a competitive-bid

process. On average, these contracts have resulted in prices that are about

one-third lower than corresponding FSS prices. Federal law also specifies

that state Medicaid programs and certain nonfederal purchasers can

receive substantial discounts on prescription drug prices. Under the

Omnibus Budget Reconciliation Act of 1990 (OBRA), drug manufacturers

must provide rebates to state Medicaid programs for their outpatient drugs

in exchange for Medicaid coverage.6 For brand-name drugs, the minimum

rebate is 15.1 percent of the average manufacturer price (AMP).7 During

fiscal year 1999, the rebates state Medicaid programs collectively received

amounted to about 19 percent of overall payments for prescription drugs.

The Public Health Service Act also provides some nonfederal purchasers,

such as community health centers and certain public hospitals, access to

drug prices based on Medicaid rebates.

Mandating that federal prices for outpatient prescription drugs be extended

to a large group of purchasers, such as Medicare beneficiaries, could lower

4 See 38 U.S.C. sec. 8126, as added by the Veterans Health Care Act of 1992 (P.L. 102-585, sec.

603).

5 The NFAMP is the weighted average price of each single form and dosage unit of a drug

that is paid to a manufacturer by wholesalers for nonfederal purchasers, taking into account

any cash discounts or similar price reductions.

6 See P.L. 101-508, sec. 4401.

7 The AMP is the weighted average price of each form and dosage unit of a drug that is paid

to a manufacturer by wholesalers for drugs distributed to the retail pharmacy class of trade,

taking into account cash discounts or similar price reductions. FSS prices and prices

associated with direct sales to HMOs and hospitals are excluded from this calculation.
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the prices they pay but raise prices for others. Such price changes could

occur because drug manufacturers would be required to charge

beneficiaries and federal purchasers the same prices. To protect their

revenues, manufacturers could raise prices for federal purchasers.

Furthermore, because federal prices are generally based on prices paid by

nonfederal purchasers, manufacturers would have to raise prices to these

purchasers in order to raise the federal prices. In particular, large private

purchasers that tend to pay lower prices, such as health maintenance

organizations (HMO) and other insurers, could see their prices rise. While it

is not possible to predict the extent or timing of any changes in

manufacturer pricing strategies if Medicare beneficiaries gained access to

the same prices available to federal purchasers, the experience following

implementation of a Medicaid rebate suggests that manufacturers would

adjust prices quickly. The magnitude of these potential effects would vary

by drug and would depend on a number of factors, including the

relationship between the specific federal price extended to Medicare

beneficiaries and the price paid by nonfederal purchasers, as well as the

number of Medicare beneficiaries with access to the federal price.

Background Prescription drug expenditures have increased substantially in recent

years.8 From 1993 to 1998, prescription drug spending grew at an average

rate of 12.4 percent per year, compared with a 5 percent average annual

growth rate for health care expenditures overall. As a result, prescription

drugs account for a growing share of total health care spending, rising from

5.6 percent in 1993 to 7.9 percent in 1998. This dramatic rise in drug outlays

has occurred for a number of reasons, including greater utilization of drugs,

the substitution of higher-priced new drugs for lower-priced existing ones,

and more direct-to-consumer advertising of drugs by manufacturers.

In the face of increasing drug expenditures, large purchasers attempt to

control their drug costs, in part, by negotiating lower prices with

manufacturers. Some purchasers deal directly with manufacturers while

other purchasers have representatives that act on their behalf. For

example, pharmacy benefit managers negotiate drug prices for many

8 See Prescription Drugs: Increasing Medicare Beneficiary Access and Related Implications

(GAO/T-HEHS/AIMD-00-100, Feb. 16, 2000). From 1993 to 1998, national expenditures for

prescription drugs grew from about $50.6 billion to about $90.6 billion.
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HMOs and insurers, while group purchasing organizations representing

thousands of the nation’s hospitals do the same. The leverage purchasers

bring to negotiations is based largely on their ability to increase the volume

used of a particular drug through mechanisms that influence physicians’

prescribing and enrollees’ purchasing practices. Using these mechanisms,

they can offer manufacturers a larger volume of sales in exchange for

bigger discounts.

To control which specific drug products they will purchase and the volume

used, HMOs and other insurers frequently create a formulary. A formulary

is a list of drugs, grouped by therapeutic class, that a purchaser prefers its

physicians to prescribe because of the drugs’ medical value and price.

Because there are often similar products competing for a share of the

market, the greater the purchaser’s ability to determine which products it

will include on its formulary, the more leverage the purchaser has to exact

lower prices from manufacturers.9 The purchaser can influence utilization

by encouraging physicians to prescribe lower-cost formulary drugs over

both higher-cost formulary and nonformulary drugs. The purchaser may

also provide financial incentives, such as reduced copayments, to

encourage its health plan members to request that physicians prescribe

lower-cost formulary drugs, including generics.10

9 Competition can exist between brand-name drugs that are therapeutically equivalent,

between brand-name drugs and generic substitutes, and between generic versions of the

same drug. Brand-name or innovator drugs generally have a patent on their chemical

formulation or on their manufacturing process. While under patent protection, they are

called single-source drugs because only the company that holds the patent produces them.

After the patent has expired, generic copies of the exact chemical formulation usually

become available and the drugs are then referred to as multiple-source drugs.

10 Because generic drugs are not patented and can be copied by different manufacturers,

they often face intense competition, which usually results in much lower prices than brandname drugs.
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Federal Price

Discounts on

Prescription Drugs

Are Significant for

Federal and

Nonfederal Purchasers

Federal law enables the federal government to use its leverage as a large

purchaser of prescription drugs to secure some of the lowest prices

available for pharmaceuticals. Through the FSS and the Medicaid rebate

programs, manufacturers must provide many of their drugs at significantly

discounted prices in exchange for having their drugs covered by Medicaid.

Federal law also sets a ceiling price on FSS brand-name drugs purchased

by select federal purchasers and extends prices based on Medicaid rebates

to many public health entities that receive federal assistance. In addition,

VA has been able to obtain some prices even lower than FSS prices through

national contracts with drug manufacturers that channel utilization to

specific products.11 Table 1 describes various federal drug prices available

to federal and nonfederal purchasers and their relationship to benchmark

prices.

11 VA refers to these as committed-use contracts.
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Table 1: Pharmaceutical Pricing Terms

a

See Office of the Inspector General, Medicaid Pharmacy−Actual Acquisition Cost of Prescription Drug

Products for Brand Name Drugs (Washington, D.C.: HHS, Apr. 1997).

b

See CBO Papers: How the Medicaid Rebate on Prescription Drugs Affects Pricing in the

Pharmaceutical Industry (Washington, D.C.: CBO, Jan. 1996, p. 20).

FSS and Ceiling Prices The FSS for pharmaceuticals contains over 17,000 products available to

federal departments, agencies, institutions, and several other entities, such

as the District of Columbia, U.S. territorial governments, and numerous

Native American tribal governments. VA is responsible for administering

the FSS and is also the schedule’s largest purchaser—about $1.2 billion in

fiscal year 1999, representing almost 83 percent of all sales at FSS prices.

Price Definition

Retail price The price charged by retail pharmacies to individuals without insurance, known as “cash-paying” customers.

Average wholesale

price (AWP)

The average list price that a manufacturer suggests wholesalers charge pharmacies. AWP is typically less than

the retail price, which will include the pharmacy’s own price markup. AWP is referred to as a sticker price

because it is not the actual price that large purchasers normally pay. For example, in a study of prices paid by

retail pharmacies in 11 states, the average acquisition price was 18.3 percent below AWP.a Discounts for HMOs

and other large purchasers can be even greater. AWP information is publicly available.

AMP The average price paid to a manufacturer by wholesalers for drugs distributed to retail pharmacies. FSS prices

and prices associated with direct sales to HMOs and hospitals are excluded. AMP was a benchmark created by

OBRA in 1990 to use in determining Medicaid rebates and is not publicly available. The Congressional Budget

Office (CBO) estimated AMP to be about 20 percent less than AWP for more than 200 drug products frequently

purchased by Medicaid beneficiaries.b

NFAMP The average price paid to a manufacturer by wholesalers for drugs distributed to nonfederal purchasers. NFAMP

is not publicly available.

FSS The price available to all federal purchasers for drugs listed on the FSS. FSS prices are intended to equal or

better the prices manufacturers charge their “most-favored” nonfederal customers under comparable terms and

conditions. Because terms and conditions can vary by drug, the most-favored customer price may not be the

lowest price in the market. FSS prices are publicly available.

Federal ceiling price

(FCP)

The maximum price manufacturers can charge for FSS-listed brand-name drugs to VA, DOD, PHS, and the

Coast Guard, even if the FSS price is higher. FCP must be at least 24 percent off NFAMP. FCP is not publicly

available.

Medicaid rebate net

price

The effective outpatient drug price after manufacturer rebates to state Medicaid programs. The basic rebate on

brand-name drugs is the greater of 15.1 percent of the AMP or the difference between AMP and the lowest or

“best” price the manufacturer charges any purchaser other than Medicaid. Rebates for generic drugs are 11

percent of the AMP. Rebates are larger for brand-name drugs whose AMP increases exceed inflation in the

consumer price index. Information on rebate amounts is publicly available; AMP and best price are not.

VA national contract

price

The price VA has obtained through competitive bids from manufacturers for select drugs in exchange for their

inclusion on the VA formulary. Contract prices are publicly available.
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According to VA, during fiscal year 1999, FSS drug sales totaled about $1.5

billion—about 1.1 percent of domestic pharmaceutical sales.12

Although manufacturers are not required to list their drug products on the

FSS, they have financial incentives to do so despite the FSS’s relatively low

prices. Manufacturers are required to list their brand-name products on the

FSS if they wish to receive reimbursement for their drugs under the

Medicaid program. Because Medicaid accounts for almost 10 percent of

domestic pharmaceutical sales, a manufacturer could lose substantial

revenues if it did not have access to this segment of the market.13 Also,

because sales under the FSS represent only a small segment of the

domestic pharmaceutical market, overall revenues are not greatly affected

by offering these prices to federal customers. Furthermore, being on the

FSS is significant to manufacturers because it enhances the likelihood that

their products will be used in VA hospitals, where many of the nations’

physicians receive part of their medical training.14

FSS prices are based on the prices that drug manufacturers charge their

“most-favored” private customers. Specifically, under General Services

Administration (GSA) procurement regulations, the FSS price is intended

to equal or better the price that the manufacturer offers its most-favored

nonfederal customer under comparable terms and conditions.15 To help VA

determine the most-favored customer price, manufacturers are required to

provide VA information on price discounts and rebates offered to domestic

customers and the terms and conditions involved, such as length of

contract periods and ordering and delivery practices. GSA regulations

recognize that because the terms and conditions of commercial sales vary,

there may be legitimate reasons why the government does not always

obtain the most-favored customer price. Hence, under the regulations, VA

12 According to IMS America, a private vendor of pharmaceutical information, in 1999 the

U.S. pharmaceutical market totaled about $142.4 billion in sales, including sales to federal

and nonfederal entities.

13 According to HCFA, Medicaid payments minus rebates for prescription drugs for fiscal

year 1999 totaled about $13.7 billion. This figure may slightly overstate the actual market

represented by Medicaid sales because Medicaid payments to pharmacies may be greater

than the actual amounts pharmacies pay for drugs.

14 For further discussion of the FSS and how FSS prices are determined, see Drug Prices:

Effects of Opening Federal Supply Schedule for Pharmaceuticals Are Uncertain

(GAO/HEHS-97-60, June 11, 1997).

15 See 48 C.F.R. sec. 538.270.
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may accept a higher price if it determines that (1) the price offered to the

government is fair and reasonable, and (2) awarding the contract is

otherwise in the best interest of the government.

VA and several other purchasers may actually pay a lower price than the

listed FSS price for many drugs, under a provision of the Veterans Health

Care Act of 1992.16 Specifically, in exchange for having their drugs covered

by Medicaid, manufacturers must sell their brand-name drugs on the FSS to

four federal purchasers—VA, DOD, PHS, and the Coast Guard—at a price

that is no higher than 76 percent of the nonfederal average manufacturer

price, known as the “federal ceiling price” or FCP. The FSS price for these

drugs for other federal purchasers may be higher than this ceiling.

Most drug products covered under the Veterans Health Care Act have FSS

prices that are slightly above their FCP. As of February 2000, the FSS prices

for products covered under the act were, on average, almost 8 percent

above the FCP. About 63 percent of the almost 6,300 products covered

under the act17 had FSS prices that were above the FCP.18 For these

products, the four purchasers protected under the act would pay only the

FCP. About 14 percent of the products covered under the act had FSS

prices equal to the FCP, and 23 percent had FSS prices that were below the

FCP. When the FSS price was lower than the ceiling, it averaged almost 6

percent below the FCP.

FSS prices can also be well below the average wholesale prices that

manufacturers suggest wholesalers charge retail pharmacies.19 Recent FSS

prices for 10 drugs commonly prescribed for the elderly were considerably

lower than AWP (see table 2).

16 See P.L. 102-585, sec. 603, codified at 38 U.S.C., sec. 8126. The provision covers innovator

multiple-source drugs, insulin, and biological products such as vaccines and antitoxins. The

provision does not cover noninnovator multiple-source or generic drugs.

17 As of February 14, 2000, the FSS included 17,464 drug products; 6,274 were covered under

the Veterans Health Care Act and 11,190 were not covered. Noncovered products are

generally generic drugs. VA estimates that about 70 percent of its drug expenditures for

fiscal year 1999 were for drugs covered under the Act.

18 About 69 percent of the covered drugs with FSS prices above the FCP had FSS prices that

were only 1 percent or less above the ceiling.

19 Because AWP reflects prices charged the retail level of trade, it is typically higher than

average manufacturer prices—AMP and NFAMP—which are charged at the wholesale level.
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Table 2: Prices for Select Prescription Drugs Commonly Used by the Elderly, February 2000

Note: These are the 10 most frequently prescribed drugs in the Pennsylvania Pharmaceutical

Assistance Contract for the Elderly in 1999. Several of these drugs have generic versions.

a

Medical Economics Company, Red Book February 2000 Update, vol. 19, no. 2 (Feb. 2000).

b

Department of Veterans Affairs, Pharmacy Benefits Management Strategic Healthcare Group,

http://www.vapbm.org (cited Feb. 14, 2000).

Brand-name drug Therapeutic category

AWPa

(dollars)

FSSb

(dollars)

Difference between

AWP and FSS prices

(percentage)

Lanoxin Cardiac glycoside $20.51 $10.05 51%

Norvasc Calcium channel blocker (high

blood pressure)

122.86 61.27 50

K-Dur 20 Potassium replacement 49.98 23.73 53

Lipitor Cholesterol-lowering 169.08 102.28 40

Lanoxin (different strength) Cardiac glycoside 20.51 10.20 50

Prilosec Gastrointestinal 119.57 58.73 51

Pepcid Gastrointestinal 53.13 18.39 65

Glucophage Oral antidiabetic 64.62 30.60 53

Fosamax Osteoporosis 60.89 33.74 45

Synthroid Thyroid $30.84 $20.91 32%
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Prices Related to Medicaid

Rebates

Many entities that receive federal assistance also obtain significant drug

discounts through federal laws. The most notable are state Medicaid

programs, which receive discounts in the form of rebates. Under OBRA, as

amended, drug manufacturers must provide all state Medicaid programs a

rebate on outpatient prescription drugs in order to have them covered by

Medicaid.20 For all brand-name products, the rebate is the greater of either

15.1 percent of AMP, or 100 percent of the difference between the AMP and

the manufacturer’s best price. The best price is essentially the lowest price

offered any domestic purchaser other than state Medicaid programs.21

Rebates for generic and over-the-counter drugs must be at least 11 percent

of AMP. To protect against substantial price increases, an additional rebate

is required for a brand-name product if its AMP increases more than the

consumer price index, a measure of overall inflation. During fiscal year

1991, state Medicaid programs paid about $5.4 billion to pharmacies for

prescription drugs and received about $553 million in rebates from

manufacturers. By fiscal year 1999, drug payments had reached about $17

billion, with rebates in excess of $3.3 billion.22

20 Rather than directly purchasing drugs, Medicaid reimburses pharmacies for drugs

purchased by Medicaid beneficiaries. Based on a formula set by the state, pharmacies are

reimbursed an amount to cover a drug product’s ingredient cost, subject to HCFA upper

limits, plus a dispensing fee.

21 Some prices are excluded in the determination of best price, such as FSS prices, prices

charged entities covered under the Veterans Health Care Act, prices to state pharmaceutical

assistance programs, prices that are nominal in amount, and single-award contract prices

charged any federal agency.

22 Rebates in the earlier years of the rebate program were based on a different percentage of

AMP. Also, according to HCFA officials, payments for fiscal year 1999 may be understated

because states do not typically submit all payment data to HCFA by the end of the fiscal

year.
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Since 1992, federal law has also required drug manufacturers to offer

certain nonfederal entities access to outpatient drugs at discounted prices

as a condition for Medicaid coverage of their outpatient drugs.23

Specifically, under Section 340B of the Public Health Service Act,24

manufacturers must provide covered entities such drugs at or below a price

equal to AMP reduced by the applicable Medicaid rebate percentage.25

Entities eligible for the price discount include hospitals that serve a

disproportionate share of Medicaid recipients; community health centers;

and health centers that serve migrant, homeless, public housing, and Native

American populations.26 A recent study estimates that, during fiscal year

1997, 1,075 entities purchased outpatient drugs at these discounts with a

total net purchase amount between $893 million and $1.2 billion.27

23 See Office of Drug Pricing, The Drug Pricing Program Established by Section 340B of the

Public Health Service Act: Information Document (Washington, D.C., Feb. 1999). The Office

of Drug Pricing (now called the Office of Pharmacy Affairs), which is within HRSA’s Bureau

of Primary Health Care, is responsible for administering the Section 340B program.

24 As added by sec. 602 of the Veterans Health Care Act of 1992.

25 The rebate percentage is the total per-unit Medicaid rebate during a calendar quarter

divided by the AMP for the quarter. HRSA’s Office of Drug Pricing indicates that the ceiling

price does not exceed AMP minus 15.1 percent for brand-name drugs and 11 percent for

generic and over-the-counter drugs. An additional rebate is required if any brand-name

product’s price exceeds the increase in the consumer price index for all items. In addition,

covered entities must ensure that drugs are not double discounted—that is, that

manufacturers do not pay a Medicaid rebate on drugs already sold to the entities at a

discounted price under Section 340B.

26 See P.L. 102-585, sec. 602.

27 See An Analysis of Purchases, Savings and Participation in the PHS Drug Pricing Program

(Mathematica Policy Research, Inc., Washington, D.C., Sep. 30, 1999).
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VA Contract Prices VA has been able to obtain prices even lower than FSS prices through

national contracts with manufacturers for select drugs. VA has obtained

such prices because it seeks competitive bids from manufacturers for

products that are therapeutically equivalent within specific drug classes.28

VA then contracts with those manufacturers whose products it believes

provide the best value, based on both medical effectiveness and price, in

exchange for including their products on VA’s national formulary and

committing to use the products throughout VA’s health care system.29

According to VA officials, the winning bids in most cases are the lowest

prices offered. During fiscal year 1999, VA purchases under national

contracts totaled about $361.3 million, or about 23 percent of its drug

expenditures. By February 2000, VA had 60 national contracts covering

about 500 products.30 For the 308 products that had both a national

contract price and an FSS price as of February 14, 2000, the national

contract price was, on average, about 33 percent lower than the FSS price.

Because national contract prices are lower than FSS prices, the price

differences between national contract prices and AWP, in turn, can be quite

large. For example, the national contract prices for three cholesterollowering drugs that are among the top 50 drug products most commonly

used by the elderly were, respectively, 70, 72, and 88 percent lower than

AWP.31

28 VA also negotiates what is known as “blanket purchase agreements” with many

manufacturers to obtain prices that are lower than listed FSS prices if VA uses specific

product amounts. These agreements differ from national committed-use contracts in that

they are not competitively bid and most apply to specific VA purchasers, such as one or

more VA hospitals. As of February 14, 2000, there were 52 blanket purchase agreements in

effect.

29 See VA Health Care: VA’s Management of Drugs on Its National Formulary (GAO/HEHS-00-

34, Dec. 14, 1999).

30 The contracts cover both brand-name and generic products and include some joint

contracts with DOD.

31 For additional information on VA national contracting practices and prices, see DOD and

VA Health Care: Jointly Buying and Mailing Out Pharmaceuticals Could Save Millions of

Dollars (GAO/T-HEHS-00-121, May 25, 2000).
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Federal Mandates

Could Raise Drug

Prices for Various

Purchasers

Extending federal prices for outpatient prescription drugs to a large group

of purchasers, such as Medicare beneficiaries, could lower the prices these

purchasers pay, but could raise prices to federal and other purchasers.

Drug manufacturers could respond to a mandate that they extend federal

prices to a larger share of purchasers by adjusting their prices to others.

The larger the group that would be newly entitled to receive a federal price,

the greater the incentive for drug manufacturers to raise that price. The

Medicaid rebate experience suggests how federal and nonfederal drug

price discounts could change if Medicare beneficiaries had access to the

same price discounts available to federal purchasers. Following enactment

of the rebate program, discounts for outpatient drugs decreased

significantly because manufacturers raised the prices they charged large

private purchasers.

Potential Price Effects of

Combining Market

Segments

Drug manufacturers have traditionally sold the same product at different

prices to distinct groups or segments of purchasers, such as HMOs, private

insurers, hospitals, and retail pharmacies. Manufacturers can segment the

market in this manner because the purchasers who receive the lower prices

do not, in turn, resell these products to other purchasers. As long as the

groups remain independent in this way, manufacturers can tailor the price

charged each group. This helps to explain why customers without drug

coverage, or cash-paying customers, typically face higher prices at a retail

pharmacy than HMOs or other large private purchasers pay.

The prices that manufacturers establish for different groups depend on

how price sensitive each group is—that is, the extent to which the group

would change the amount of a product it buys if the price rises or falls. For

example, HMOs are more price sensitive than retail pharmacies because

HMOs exercise control over the particular products they purchase through

the use of formularies and other mechanisms that influence physicians’

prescribing practices. Conversely, retail pharmacies have limited ability to

determine which drugs they must have available because physicians’

prescribing practices are largely outside their influence. Retail pharmacies

must, therefore, stock a wide range of drug products that meet the needs of

all of their customers, regardless of changes in price for those products.

If manufacturers were required to provide their drug products to both retail

pharmacies and HMOs at the same prices, these two market segments

would no longer be independent. Manufacturers would have to decide

whether to provide retail pharmacies the same prices they have typically
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provided HMOs, or raise their prices to HMOs to minimize the negative

impact on their profits. To assess the potential impact on profits,

manufacturers would need to assess how much of their revenue they would

lose by charging retail pharmacies the lower HMO prices, versus any losses

in sales due to raising the prices to HMOs and other large private

purchasers. Manufacturers would recognize that raising prices to these

large purchasers could result in decreased sales. Manufacturers would

likely temper their price changes depending on how price sensitive large

purchasers were. If large purchasers were very price sensitive, sharply

restricting their purchases as prices rose, manufacturers might restrain

their price increases. If large purchasers were less price sensitive,

manufacturers could raise prices more while experiencing the loss of fewer

sales. The net result of requiring that retail pharmacies and large

purchasers pay the same prices would likely be higher prices for those who

had previously benefited from lower prices and lower prices for those who

had not.

Extending federal prices to a large group of purchasers, such as Medicare

beneficiaries, could have similar pricing implications. Large groups of

purchasers that pay very different prices based on their price sensitivity

would be combined and manufacturers would be required to charge

everyone in the enlarged combined group the same price. The magnitude of

the price effects would depend considerably on which federal price was

provided and the number of beneficiaries that would now purchase drugs

at that federal price.32 For example, if the FSS price were extended to

Medicare beneficiaries, the market segments that included FSS purchasers

and cash-paying retail Medicare customers would be combined. In this

case, the federal price would be based on prices paid by manufacturers’

most-favored customers, and the volume of sales at the FSS price would be

significantly larger than at present. Depending on the number of Medicare

beneficiaries that would purchase their drugs at FSS prices, sales at FSS

32 For further discussion of the potential effects of extending FSS prices to nonfederal

purchasers, see GAO/HEHS-97-60 (June 11, 1997).
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Page 18 GAO/HEHS-00-118 Federal Drug Discounts

prices could be between 6 and 20 times larger than the current level.33 How

much manufacturers might charge would vary by product, depending

considerably on whether there were competing products, as well as the

price sensitivity of the manufacturers’ other customers. However, for those

products whose retail and most-favored customer prices were considerably

different, manufacturers would have the incentive to charge a new price

that would likely fall somewhere between the two to offset any reduction in

revenues. In these cases, extending the FSS price to Medicare beneficiaries

could result in important out-of-pocket savings, particularly for cashpaying beneficiaries.34 However, it could also raise the prices paid by

private and federal purchasers, as increases in the prices manufacturers

charged their best customers would, in turn, increase FSS prices.

Medicaid Rebate

Experience

Federal efforts to provide state Medicaid programs discounts on

prescription drugs demonstrate the potential price effects of mandating a

federal price or discount that, in effect, combines purchasers from different

market segments. Before the Medicaid rebate program was enacted, state

Medicaid programs were paying near-retail prices for outpatient drugs,

although collectively they were the largest single purchaser of prescription

drugs. OBRA required that manufacturers provide rebates to state

Medicaid programs on outpatient drugs based on the lowest prices they

charged other purchasers. After the rebate program’s enactment, the

discounts that large private purchasers, such as HMOs and hospitals,

33 In 1996, Medicare beneficiaries with drug coverage spent an average of $769 on

prescription drugs; beneficiaries without coverage spent an average of $463. If the

approximate 12 million beneficiaries that lacked drug coverage had access to FSS prices

and those prices were lower than the prices they would pay otherwise, it could increase the

volume of drugs they would purchase. Therefore, if their drug spending at FSS prices

increased to about the same amount as those with coverage, sales at FSS prices would be

about $9.2 billion, or over six times greater than total FSS sales in fiscal year 1999. If all 39

million beneficiaries had access to FSS prices and spent an annual average of $769 on drugs,

FSS sales would be about $30 billion or about 20 times greater than total FSS sales in fiscal

year 1999. Based on data from the 1996 Medicare Current Beneficiary Survey. See J.A. Poisal

and G.S. Chulis, “Medicare Beneficiaries And Drug Coverage,” Health Affairs (Mar./Apr.

2000), p. 252.

34 Other beneficiaries with drug coverage, such as those enrolled in Medicare HMOs, may

already receive drugs at discounted prices.
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Page 19 GAO/HEHS-00-118 Federal Drug Discounts

received for many outpatient drugs dropped substantially.35 Within 2

years,we found that the average best-price discount for the drugs they

purchased was no greater than 15.3 percent of AMP—about the mandated

minimum rebate for Medicaid programs.36 This was confirmed by a CBO

analysis that concluded that manufacturers were much less willing to give

steep discounts to large purchasers when they had to give the same

discounts to Medicaid.37

Summary By using its purchasing power, principally derived from the large purchases

covered by the Medicaid program, the federal government obtains

significantly discounted prices for prescription drugs from drug

manufacturers for both federal and select nonfederal entities. Extending

federal prices to Medicare beneficiaries could result in their paying less for

drugs. However, these lower prices could come with a trade-off—federal

and nonfederal purchasers might pay more if drug manufacturers raise

prices to them to offset revenue losses resulting from extending federal

prices to Medicare beneficiaries. The extent to which prices would change

would vary by drug and would depend on many factors, including the

number of Medicare beneficiaries affected, whether a drug had

competition, and the price sensitivity of private purchasers. The decrease

in price discounts following enactment of the Medicaid rebate program

demonstrated the potential effects of reducing manufacturers’ ability to

differentiate among purchasers and charge some purchasers higher prices

than others.

35 See Medicaid: Changes in Best Price for Outpatient Drugs Purchased by HMOs and

Hospitals (GAO/HEHS-94-194FS, Aug. 5, 1994). Also, see Medicaid: Changes in Drug Prices

Paid by HMOs and Hospitals Since Enactment of Rebate Provisions (GAO/HRD-93-43, Jan.

15, 1993).

36 This is average percentage that the best price was below the AMP. The average best price

discount decreased because the average best price increased faster than the AMP during the

2-year period.

37 See CBO Papers: How the Medicaid Rebate on Prescription Drugs Affects Pricing in the

Pharmaceutical Industry (Washington, D.C., Jan. 1996). CBO also noted that many FSS

prices increased significantly, perhaps because FSS prices were initially considered with

private-sector prices in calculating rebates. In 1992, in the Veterans Health Care Act, the

Congress exempted all drug prices paid by federal entities from rebate calculations.
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Page 20 GAO/HEHS-00-118 Federal Drug Discounts

Agency and Other

Comments

We obtained comments on the draft report from VA officials associated

with pharmaceutical purchasing and pharmacy benefit management,

including the Executive Director and Chief Operating Officer of the

National Acquisition Center and the Chief Consultant for the Pharmacy

Benefits Management Strategic Healthcare Group. We also obtained

comments from two nationally known researchers on pharmaceutical

pricing issues. The reviewers agreed with our findings and provided

technical comments, which we have incorporated where appropriate.

As agreed with your office, unless you publicly announce its contents

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questions about this report, please call me at (202) 512-7114, or John

Hansen at (202) 512-7105. Others who made major contributions to this

report include Joel Hamilton, Elsie Picyk, and George Bogart.

Laura A. Dummit

Associate Director, Health Financing

and Public Health Issues

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