United States General Accounting Office

GAO Testimony

Before the Subcommittee on Health, Committee on

Veterans’ Affairs, House of Representatives

For Release on Delivery

Expected at 9:30 a.m.

Thursday, July 10, 1997

FEDERAL DRUG PRICES

Effects of Opening the

Pharmaceutical Schedule

Are Uncertain

Statement of Bernice Steinhardt, Director

Health Services Quality and Public Health Issues

Health, Education, and Human Services Division

GAO/T-HEHS-97-171

Federal Drug Prices: Effects of Opening the

Pharmaceutical Schedule Are Uncertain

Mr. Chairman and Members of the Subcommittee:

We are pleased to be here today to discuss our recent report on the

potential implications for the Department of Veterans Affairs (VA) and

other government purchasers of opening the federal supply schedule (FSS)

for pharmaceuticals to state and local governments.1

 During fiscal year

1996, the federal government purchased almost $1.3 billion worth of

pharmaceuticals from this catalog of drug prices. As you know, schedule

prices are often substantially lower than retail prices and are available

primarily to federal purchasers. VA used this schedule to purchase about

$922 million in pharmaceuticals—about 71 percent of the government’s

total purchases from the schedule.

In 1994, the Congress authorized the General Services Administration

(GSA) to administer a cooperative purchasing program that would allow

state, local, and Indian tribal governments, as well as the Commonwealth

of Puerto Rico, to purchase pharmaceuticals and other goods and services

from federal supply schedules.2 VA, to which GSA has delegated

administration of the pharmaceutical schedule, expressed concern that

prices on the schedule could increase if it was opened to a larger group of

purchasers. As a result, GSA proposed that the pharmaceutical schedule be

excluded from the cooperative purchasing program because GSA did not

plan to open any schedule to nonfederal entities if higher schedule prices

would result.

Because of concerns about the potential effects of opening more than 140

federal supply schedules, the Congress directed GSA to delay opening any

schedule pending completion of our assessment of the potential impact.3

GSA is currently developing its final implementation plan for opening the

schedules.

Today I would like to discuss the factors that could affect schedule price

negotiations between VA and drug manufacturers if the pharmaceutical

schedule was opened, as well as the opening’s potential effects on the

1

Drug Prices: Effects of Opening Federal Supply Schedule for Pharmaceuticals Are Uncertain

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

2

See the Federal Acquisition Streamlining Act of 1994, P.L. 103-355, sec. 1555 (1994).

3

See the National Defense Authorization Act for Fiscal Year 1996, P.L. 104-106, sec. 4309 (1996) and

accompanying conference report, H.R. Conf. Rep. No. 104-450, at 970 (1996). The implications of

opening other schedules are discussed in Cooperative Purchasing: Effects Are Likely to Vary Among

Governments and Businesses (GAO/GGD-97-33, Feb. 10, 1997).

Page 1 GAO/T-HEHS-97-171
Federal Drug Prices: Effects of Opening the

Pharmaceutical Schedule Are Uncertain

schedule prices that would be available to federal, state, and local

government purchasers.

To assess the potential impact of opening the schedule, we contacted VA,

other federal agencies, and the Congressional Budget Office (CBO). We also

contacted the Public Hospital Pharmacy Coalition,4

 the Health Industry

Group Purchasing Association (HIGPA),5

 the National Association of Chain

Drug Stores, the Pharmaceutical Research and Manufacturers of America

(PhRMA), and several drug manufacturers.6

 In addition, we analyzed

schedule prices and reviewed assessments made by VA, HIGPA, and the

Coalition concerning how opening the schedule could affect schedule and

other drug prices.

In summary, the effects of opening the pharmaceutical schedule on

schedule prices ultimately depend on the outcome of negotiations

between VA and drug manufacturers. Because of many uncertainties

related to these negotiations, it is not possible to predict how the

schedule’s prices would change or what the ultimate impact on VA and

other government purchasers would be.

Although many factors would influence the negotiations between VA and

drug manufacturers, two primary ones are VA’s negotiating ability and

manufacturers’ pricing strategies. Both of these factors would be

influenced by the size of the market represented by combined federal,

state, and local purchasers that would have access to schedule prices.

Moreover, the size of this market could affect the size of any resulting

price changes. The larger the market, the greater the economic incentive

would be for a manufacturer to raise schedule prices to limit the impact of

giving low prices to more purchasers.

At present, federal purchases from the schedule represent about

1.5 percent of the total dollar value of domestic pharmaceutical sales.

Estimates of the size of a combined federal, state, and local market,

however, vary widely because of uncertainty about which state and local

entities would be eligible for schedule prices. If eligibility is not narrowed,

VA, PhRMA, drug manufacturers, and the Public Hospital Pharmacy Coalition

4

The Coalition represents 70 public hospitals that are owned or controlled by state and local

governments and serve a disproportionate share of Medicaid and indigent patients.

5

HIGPA is a national trade association that represents 84 organizations and vendors that purchase

pharmaceutical and other medical products.

6

The manufacturers we contacted were Eli Lilly and Company; Johnson & Johnson; Merck & Co., Inc.;

Pfizer Inc.; and SmithKline Beecham Corporation.

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Federal Drug Prices: Effects of Opening the

Pharmaceutical Schedule Are Uncertain

agree that the size of the combined market could be significantly larger

than the current federal market. Although the Coalition estimates that

limiting eligibility as it suggests could keep state and local purchases from

the schedule at between 0.5 and 4.4 percent of domestic pharmaceutical

sales, this would result in a combined market about 33 to 300 percent

larger than the federal market.

Federal efforts to lower Medicaid drug prices suggest how opening the

schedule could put upward pressure on schedule prices. In 1990, the

Congress required drug manufacturers to give state Medicaid programs

rebates for outpatient drugs based on the lowest prices they charged other

purchasers. Because of the size of the Medicaid market, however, many

drug manufacturers sought to minimize the impact of the rebates on their

business by raising outpatient drug prices to some private sector

purchasers.

If the pharmaceutical schedule was opened to state and local governments

and drug manufacturers succeeded in raising their schedule prices in

response, the impact on different government purchasers would vary. VA,

along with the Department of Defense (DOD), the Public Health Service,

and the Coast Guard, would be somewhat protected from price increases

because the Veterans Health Care Act of 19927

 sets maximum prices for

these agencies for over one-quarter of the drugs on the schedule. Other

federal purchasers would not have that protection. State and local

government purchasers, meanwhile, would benefit to the extent that

schedule prices were lower than the prices they or their representatives

could negotiate with drug manufacturers.

Background The FSS for pharmaceuticals currently contains almost 23,000 products

available to federal agencies and institutions and several other purchasers.

The purpose of the pharmaceutical schedule, like other supply schedules,

is to provide eligible entities an efficient and economical option for

purchasing. These entities can purchase pharmaceuticals, however,

through other methods. For example, although VA depends on the FSS for

most of its drug purchases, VA has awarded several national contracts on a

competitive basis for specific drugs it considered to be therapeutically

interchangeable.

Under the Veterans Health Care Act of 1992, drug manufacturers must

make their brand-name drugs available through the FSS in order to receive

7

See P.L. 102-585, sec. 603.

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Federal Drug Prices: Effects of Opening the

Pharmaceutical Schedule Are Uncertain

reimbursement for drugs covered by Medicaid.8 The act also requires drug

manufacturers to sell drugs covered by the act to four agencies—VA, DOD,

the Public Health Service, and the Coast Guard—at no more than

76 percent of the nonfederal average manufacturer’s price,9

 a level

referred to as the “federal ceiling price” (FCP). A drug’s FSS price may be

higher or lower than its FCP. If it is higher, the protected purchasers pay no

more than the FCP.

GSA published in the Federal Register on April 7, 1995, its initial proposed

plan for opening the federal supply schedules to state and local

governments. The plan proposed excluding from cooperative purchasing

the schedule for drugs and pharmaceutical products and one medical

equipment and supplies schedule10 because GSA concluded that opening

them would have the unintended effect of increasing costs to federal users

of the schedules. The plan also proposed that participation in the

cooperative purchasing program be optional for sellers and purchasers.

Impact of Opening the

FSS Depends Largely

on Price Negotiations

Price negotiations between VA and drug manufacturers will ultimately

determine the extent to which opening the pharmaceutical FSS affects the

schedule drug prices available to federal, state, and local governments.

Opening the schedule could change the dynamics of negotiating FSS prices

for both VA and drug manufacturers. Up to now, VA has been able to obtain

significant discounts from drug manufacturers by seeking the

most-favored customer price. This price represents the same discount off

a drug’s list price that the manufacturer offers its most-favored nonfederal

customer under comparable terms and conditions, such as length of

contract periods and ordering and delivery practices. Many FSS prices are

more than 50 percent below nonfederal average manufacturer prices.11

Representatives of several drug manufacturers explained that their

companies have been willing to negotiate low FSS prices because they

consider the FSS to be a special, limited category of pricing.

8

See P.L. 102-585, sec. 603. The act does not cover generic drugs.

9

The nonfederal average manufacturer price is the weighted average price of each single form and

dosage unit of a drug that is paid by wholesalers in the United States to a manufacturer, taking into

account any cash discounts or similar price reductions. Prices paid by the federal government are

excluded from this calculation.

10VA contended that some items on this schedule, which includes in vitro diagnostic substances,

reagents, test kits, and sets, could also increase in price if it was opened. The implications of opening

this schedule are covered in GAO/GGD-97-33, Feb. 10, 1997.

11The cost of drugs covered by the Veterans Health Care Act that had FSS prices below federal ceiling

prices as of Sept. 30, 1996, was, on average, 52 percent below the nonfederal average manufacturer

price. See GAO/HEHS-97-60, June 11, 1997.

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Federal Drug Prices: Effects of Opening the

Pharmaceutical Schedule Are Uncertain

Representatives of two manufacturers specifically noted that their

companies agreed to such prices to help ensure that their drugs were

widely used in VA hospitals, where many of the nation’s physicians receive

part of their training. Some drug manufacturers have indicated an

unwillingness, however, to continue to offer such low prices if the FSS is

opened to a larger group of purchasers and federal purchasers are

combined with other types of government purchasers that the

manufacturers have considered to be part of a separate market.

Although VA would be negotiating on behalf of a larger market if the

schedule was opened, the increased market share might not in and of itself

improve VA’s leverage to negotiate lower prices. Drug manufacturers have

historically offered different prices for the same product to different

purchasers largely on the basis of the purchaser’s ability to influence drug

utilization (sometimes referred to as the ability to move market share).12

For this reason, volume of sales, while integral to price negotiations

between purchasers and drug manufacturers, is not the only important

consideration. A common technique used by large-volume purchasers to

influence market share is to establish a formulary. A formulary is a list of

drugs that a health plan prefers its physicians to prescribe for patients.

Drugs are included on a formulary not only for their medical value but also

for their favorable prices. Both inclusion of a drug on a formulary and the

drug’s cost can affect how much it is prescribed and purchased and,

therefore, have an impact on its market share. Because formularies have

the potential to significantly affect the sales of drugs, large purchasers that

use them have greater leverage in negotiating discounts or rebates with

manufacturers who want their drugs listed as preferred drugs. However,

because the FSS is a catalog of prices, not a formulary, VA lacks that kind of

leverage.

If drug manufacturers are unwilling to extend low FSS prices to state and

local purchasers, VA could experience a “showdown” with manufacturers

over price increases, which it has not experienced before. Drug

manufacturers could respond in several ways. First, they could simply

refuse to offer their products to state and local purchasers at FSS prices, an

option that is permitted under GSA’s current proposal. Representatives of

several manufacturers told us, however, that they do not consider this

option realistic because some competing manufacturers would be likely to

offer FSS prices to state and local purchasers, and no manufacturer would

want to concede the potential business. Second, drug manufacturers could

12See CBO Papers: How the Medicaid Rebate on Prescription Drugs Affects Pricing in the

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

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Federal Drug Prices: Effects of Opening the

Pharmaceutical Schedule Are Uncertain

try to increase FSS prices by raising prices to most-favored customers to

change the base on which prices are negotiated with VA. Several

manufacturers indicated that this option would depend on the size of the

market represented by all government purchasers. Third, drug

manufacturers could attempt to negotiate higher FSS prices without linking

them to most-favored customer prices. This strategy could result in

lengthy, difficult negotiations, which VA has not experienced before with

manufacturers.

Size of Market Eligible for

FSS Prices Would Be Key

Factor

The size of the FSS market if the schedule was opened would be a key

factor in determining what would happen to drug prices. The larger the

market, the greater the incentive would be for manufacturers to raise FSS

prices to limit the impact on their business of giving low prices to more

purchasers. GSA’s proposed implementation plan for opening the schedules

included participation by a state and any department, agency, or political

subdivision of a state, including local governments. Representatives of VA,

PhRMA, drug manufacturers, HIGPA, and the Public Hospital Pharmacy

Coalition agree that unless this definition of an eligible entity is narrowed,

the FSS market could expand significantly from its current size of about 1.5

percent of domestic pharmaceutical sales.13

The Coalition has suggested that GSA’s definition be narrowed to limit

access to FSS prices to state and local government entities that purchase

drugs for their own use and dispense drugs in their own facilities. The

Coalition estimated that defining eligibility this way would result in a state

and local FSS market of about 4.4 percent of total dollars in domestic

pharmaceutical sales.14 But the market might actually be considerably

smaller, according to the Coalition, because some state and local

purchasers are subject to procurement laws or regulations that would

restrict their participation in cooperative purchasing. Also, eligible state

and local purchasers would not buy all their drugs from the FSS because it

is likely that not all FSS prices would be lower than other prices available

to them. If these two assumptions were considered, the Coalition

estimated that state and local FSS purchases would fall from about

4.4 percent to 0.5 percent of the total drug market. Therefore, the

13According to IMS America, a private vendor of pharmaceutical information, in 1996 the U.S.

pharmaceutical market totaled about $85.4 billion in sales, including sales to federal, state, and local

government entities. FSS drug sales of about $1.3 billion for fiscal year 1996 represent about

1.5 percent of U.S. pharmaceutical sales.

14See PRIME Institute, College of Pharmacy, University of Minnesota, Section 1555 of the Federal

Acquisition Streamlining Act: Impact of Cooperative Purchasing on the Pharmaceutical Market,

prepared for the Public Hospital Pharmacy Coalition (Washington, D.C.: Jan. 15, 1997).

Page 6 GAO/T-HEHS-97-171
Federal Drug Prices: Effects of Opening the

Pharmaceutical Schedule Are Uncertain

Coalition’s estimates mean that the total FSS market would expand by

about 33 to 300 percent if state and local governments are given access to

FSS prices.

As for the impact of procurement laws or regulations on state and local

participation, 27 of 50 respondents15 reported in a September 1996 survey

we conducted that current state competitive-bidding and other laws would

limit their use of federal supply schedules.16 But most state and local

government purchasing officials we contacted indicated that they want the

option of purchasing items from the schedules. How many states and

localities would change purchasing laws and regulations so that they could

participate in the cooperative purchasing program is uncertain. It is also

uncertain how many and to what extent eligible state and local entities

would choose to buy drugs through the FSS.

Although the size of the combined federal, state, and local market that

could have access to FSS prices is unclear, past federal efforts to lower

drug prices for a significant market caused many manufacturers to raise

prices. Before the Medicaid rebate program was enacted in 1990, state

Medicaid programs, which represent about 11 percent of the domestic

pharmaceutical market,17 paid close to retail prices for outpatient drugs.

Other purchasers, such as hospitals and health maintenance organizations,

paid considerably less. Under the program, the Congress required drug

manufacturers to give state Medicaid programs rebates for outpatient

drugs on the basis of the lowest prices they charged other purchasers.

After the rebate program’s enactment, the prices many large private

purchasers paid for outpatient drugs increased substantially.18 In

particular, prices paid by health maintenance organizations rose, on

average, more than twice as fast as the year before the program. On the

basis of its analysis of these price changes for outpatient drugs, CBO

concluded that, because of the size of the market represented by Medicaid,

“pharmaceutical manufacturers are much less willing to give large private

15Respondents represented 48 states and 2 territories.

16See GAO/GGD-97-33, Feb. 10, 1997.

17According to IMS America, in 1995 total sales for the U.S. pharmaceutical market were about

$77.1 billion. According to the Health Care Financing Administration, Medicaid drug expenditures for

fiscal year 1995 totaled about $8.4 billion, including rebates.

18See Medicaid: Changes in Drug Prices Paid by HMOs and Hospitals Since Enactment of Rebate

Provisions (GAO/HRD-93-43, Jan. 15, 1993) and Medicaid: Changes in Best Price for Outpatient Drugs

Purchased by HMOs and Hospitals (GAO/HEHS-94-194FS, Aug. 5, 1994).

Page 7 GAO/T-HEHS-97-171
Federal Drug Prices: Effects of Opening the

Pharmaceutical Schedule Are Uncertain

purchasers steep discounts off the wholesale price when they also have to

give Medicaid access to the same low price.”19

FSS Price Changes

Would Affect

Government

Purchasers Differently

Although it is uncertain how FSS prices would change if the pharmaceutical

FSS is opened, the factors involved in negotiations between VA and drug

manufacturers have the potential to produce, in general, an upward

pressure on FSS prices.

For VA and Other Federal

Purchasers, Impact of Any

FSS Price Increases Would

Vary

If FSS prices rise after the schedule is opened, all federal purchasers could

pay higher FSS prices for many drugs covered and not covered by the

Veterans Health Care Act. About 73 percent of the roughly 22,800 drugs on

the FSS are not covered by the act.20 However, these drugs represent a

smaller portion of federal expenditures because they are primarily generic

equivalents of brand-name drugs. A VA official estimated that about

three-quarters of VA’s total drug expenditures are for covered drugs. For

these drugs, VA and the three other protected federal agencies would not

have to pay FSS prices that are higher than the FCPs. But as figure 1 shows,

they may have to pay more for the 8 percent of all FSS drugs that currently

have FSS prices below their ceiling prices if prices rise to or above the FCPs.

The FSS prices for these drugs are, on average, about 28 percent below the

FCP.

19See CBO Papers.

20As of Sept. 30, 1996, the FSS included 22,828 products—6,243 were covered drugs and 16,585 were

not covered.

Page 8 GAO/T-HEHS-97-171
Federal Drug Prices: Effects of Opening the

Pharmaceutical Schedule Are Uncertain

Figure 1: FSS Price Relative to the FCP

for Schedule Drugs as of

September 30, 1996

16.9% •

FSS Price Above FCP

• 2.4%

FSS Price Same as FCP •

8.0%

FSS Price Below FCP

72.7%•

FSS Price Not Subject to FCP

Not Covered by the Veterans Health Care Act

Covered by the Veterans Health Care Act

Note: Percentages are based on the number of FSS products, rather than on FSS expenditures.

Source: VA data.

In February 1995, VA presented GSA its analysis of the potential effects of

opening the pharmaceutical schedule on FSS prices and VA drug costs,

taking into consideration the protection the Veterans Health Care Act

provides VA against drug price increases. On the basis of discussions with

representatives of numerous drug manufacturers, VA made two key

assumptions in its analysis about the potential effects of opening the

pharmaceutical FSS: (1) drug manufacturers would eliminate FSS pricing for

all drugs not covered by the Veterans Health Care Act, forcing federal

purchasers to buy these generic drugs at higher wholesale prices, and

(2) FSS prices for all drugs covered by the act would rise to their FCPs.

Page 9 GAO/T-HEHS-97-171
Federal Drug Prices: Effects of Opening the

Pharmaceutical Schedule Are Uncertain

VA applied those two assumptions to drug purchases it made during the

first 6 months of 1994.21 According to VA, it spent about $37.8 million on

4,877 generic drugs not covered by the act. If it had purchased the same

drugs at wholesale rather than FSS prices, VA estimated that it would have

paid over $79.7 million, or about 111 percent more. In the same period, VA

spent about $118.3 million on 911 brand-name drugs that were covered by

the act and that had FSS prices below their FCPs. Had the manufacturers of

those drugs raised the FSS prices to their FCPs, VA estimated that it would

have paid over $152.9 million, or roughly 29 percent more. Thus, VA

calculated that, on an annualized basis, the impact of giving state and local

governments access to the FSS would have been a $153.1 million increase

in its yearly drug expenditures.

Those federal purchasers that, unlike VA, have no protection from the

ceiling prices established by the Veterans Health Care Act would pay full

FSS prices on all drugs bought from the schedule. As of November 1996,

only 25 of 162 drug manufacturers had FSS prices that were above the FCP.

But, manufacturers may offer purchasers not protected by the act prices

above the FCP. Representatives of several drug manufacturers told us that

their companies would consider this option attractive if the

pharmaceutical schedule was opened because it would allow them to offer

prices above the FCP to state and local purchasers. Federal purchasers not

protected by the ceiling prices would pay the full amount of such price

increases.

The potential impact of FSS price increases on different government

purchasers when purchasing from the pharmaceutical schedule is

summarized in table 1.

21According to VA, calculations were based on actual contract purchase prices from VA’s prime vendor

network from Jan. 1 through June 30, 1994.

Page 10 GAO/T-HEHS-97-171
Federal Drug Prices: Effects of Opening the

Pharmaceutical Schedule Are Uncertain

Table 1: Potential Effects of FSS Price Increases on FSS Prices Paid by Government Purchasers

FSS price paid

Purchaser Before FSS opened After FSS opened Implications

VA, DOD, Public Health Service,

and Coast Guard

Lower of FSS or FCP for

covered drugs; FSS for drugs

not covered

Lower of FSS or FCP for

covered drugs; FSS for drugs

not covered

FSS price for 8% of drugs could

increase up to FCP; FSS price

could increase for many drugs

not covered.

Other federal government entities FSS FSS FSS prices could increase for

many drugs covered and not

covered.

State and local government

entities

Not applicable— negotiated

prices

FSS FSS prices, even if they

increase, could be lower than

prior negotiated prices; if they

are not, purchasers could try to

negotiate lower prices.

Note: For the purpose of this table, federal purchasers are considered to be dependent on

purchasing many of their drugs from the FSS rather than from alternative sources.

State and Local Purchasers

Could Choose Between

FSS and Other Drug Prices

Opening the pharmaceutical schedule would give state and local

purchasers the choice of buying drugs from the FSS or from other sources.

The Public Hospital Pharmacy Coalition contends that state and local

purchasers would benefit from having access to the schedule and

manufacturers would have little incentive to raise FSS or other drug prices

because

• a manufacturer’s participation in the cooperative purchasing program is

voluntary, thus allowing a company to opt out of the program if it

anticipates any adverse economic consequences;

• if a manufacturer concludes that it must participate in the program for

competitive reasons, the same competitive forces will keep prices from

rising;

• the potential size of the state and local market will be small, given the

Coalition’s proposal for determining eligibility to access FSS drug prices;

and

• market size is but one of many factors drug manufacturers consider in

developing drug pricing strategies.

Assuming negligible adverse effects on FSS prices if the schedule is

opened, the Coalition anticipates considerable financial benefits for many

state and local purchasers. For example, a Coalition analysis of the

differences between FSS prices and the prices nine public hospitals paid for

Page 11 GAO/T-HEHS-97-171
Federal Drug Prices: Effects of Opening the

Pharmaceutical Schedule Are Uncertain

the 100 drugs each hospital spends the most on showed that FSS prices, on

average, were lower than the hospitals’ purchase prices for about

83 percent of the drugs.22 FSS prices were, on average, about 17 percent

lower than the prices the hospitals paid.

If the pharmaceutical schedule is opened and FSS prices rise, the extent to

which state and local government purchasers could benefit is unclear. The

drug prices paid by the hospitals in the Coalition’s analysis show that

many FSS prices could rise and still be lower than what some state and

local purchasers currently pay. If FSS prices remained higher than what

state and local purchasers were accustomed to paying, they could try to

negotiate better prices for themselves. However, the incentive for a drug

manufacturer to negotiate a price below the FSS price would be limited

because the negotiated price could become the most-favored customer

price and, thus, potentially affect the manufacturer’s FSS price negotiations

with VA. In any case, VA and other federal purchasers would still face an

increase in FSS prices.

Mr. Chairman, this concludes my prepared statement. I would be pleased

to respond to any questions you or Members of the Subcommittee may

have.

(108338)

22The analysis was based on FSS and hospital purchase prices as of Oct. 1, 1996.

Page 12 GAO/T-HEHS-97-171
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