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The Omnibus Budget Reconciliation Act of 1990 established the Medicaid rebate program for outpatient prescription drugs. That program requires pharmaceutical manufacturers to rebate to the federal and state governments a portion of their revenues from sales to Medicaid patients. In response to a request by the Senate Budget Committee, this Congressional Budget Office (CBO) paper examines both how much the Medicaid rebate program has saved federal and state governments and how it has affected pricing in the pharmaceutical industry. At the end of November, the Congress passed the Balanced Budget Act of 1995, which the President vetoed. The act would have shifted responsibility for the Medicaid program to the states, with continued federal support through block grants. The rebate program would have continued much as before.

Anna Cook of CBO's Natural Resources and Commerce Division and Scott Harrison, formerly of CBO's Budget Analysis Division (now at Price Waterhouse), wrote the paper under the supervision of Jan Paul Acton and Elliot Schwartz. Joseph Antos, Linda Bilhdmer, Amy Downs, Anne Hunt, and Neal Masia of CBO provided valuable comments and assistance. Outside CBO, Joel Hamilton, John Hansen, and William Comanor also provided useful reviews.

Paul Houts edited the report, and Christian Spoor provided editorial assistance. Rae Wiseman prepared the paper for publication.

June E. O'Neill Director
January 1996
 
 

SUMMARY

I - INTRODUCTION

II - HOW MEDICAID AND THE REBATE PROGRAM WORK

• Medicaid
• The Medicaid Rebate Program

III - PRICING IN THE PHARMACEUTICAL INDUSTRY AND THE MEDICAID REBATE

• Who Gets Discounts
• Price Discrimination and the Medicaid Rebate

IV - HOW THE MEDICAID REBATE HAS AFFECTED PRICING

• Changes in the Best-Price Discounts Between 1991 and 1994
• Changes in the Average Basic Rebate Between 1991 and 1994

V - OPTIONS FOR CHANGING THE BEST-PRICE PROVISION

APPENDIX - Price Discrimination and the Medicaid Rebate: A Model
 

TABLES
S-1.	Medicaid Expenditures on Prescription Drugs, 1984-1994
1.	Medicaid Expenditures on Generic and Brand-Name Drugs, 1993
2.	Changes in the Medicaid Rebate Rules Between 1991 and 1996
3.	Share of the Medicaid Market for Top-Selling Prescription Drugs
4.	Average Best-Price Discounts, 1991-1994
5.	How Best-Price Discounts Changed Between 1991 and 1994
6.	Percentage Change in Price Indexes, 1991-1994
7.	Annual Change in the Producer Price and Consumer Price Indexes, 1974-1994
8.	Changes in the Average Best-Price Discount and Basic Rebate Between 1991 and 1994
9.	The Effect of Combining a Cap on the Basic Rebate with a Higher Minimum Rebate to Maintain Budget Neutrality
FIGURES
1.	Channels of Prescription Drug Distribution
2.	Illustrative Relationships Between the Best Price and the Average Manufacturer Price
3.	Weighted Average Best-Price Discount, 1991 -1994
4.	Unweighted Average Best-Price Discounts, 1991-1994
5.	Distribution of Best-Price Discounts for All Brand-Name Drugs
6.	Distribution of Best-Price Discounts for Single-Source Drugs
7.	Distribution of Best-Price Discounts for Multiple-Source Drugs
8.	Best-Price Discounts for Single-Source Drugs
9.	Weighted Average Basic Rebate, 1991-1994
BOXES
1.	The Additional Rebate: Some Examples
2.	Comparing the Average Manufacturer Price with the List Price
3.	Federal Supply Schedule Prices and the Average Best-Price Discount

 
 

The Medicaid rebate program, established by the Omnibus Budget Reconciliation Act of 1990, has succeeded in reducing government spending on outpatient prescription drugs. Under the basic rebate formula, pharmaceutical manufacturers rebate to the states at least 15.1 percent of the wholesale price of brand-name drugs that Medicaid beneficiaries purchase as outpatients. The basic rebate is often higher than that 15.1 percent minimum because of a "best-price" provision that gives Medicaid access to the lowest price paid by any other purchaser in the United States. In fiscal year 1994, Medicaid payments for outpatient prescription drugs totaled $9.5 billion. The total rebates paid came to $1.8 billion, thereby reducing net Medicaid payments for outpatient prescription drugs to $7.7 billion (see Summary Table).
 

Although the basic rebate has lowered Medicaid's expenditures on outpatient prescription drugs, spending on prescription drugs by non-Medicaid patients may have increased as a result of the Medicaid rebate program. In particular, the best-price provision has increased the prices paid by some purchasers in the private sector. Since Medicaid constitutes between 10 percent and 15 percent of the market for outpatient prescription drugs, pharmaceutical manufacturers are much less willing to give large private purchasers steep discounts off the wholesale price when they also have to give Medicaid access to the same low price. As a result, the largest discounts that pharmaceutical manufacturers give off the wholesale price-the best-price discounts-have fallen from an average of more than 36 percent in 1991 to 19 percent in 1994. Hence, although the Medicaid rebate appears on the surface to be attractive, it may have had unintended consequences for private purchasers. Rather than continuing to give Medicaid access to the lowest prices available in 1991, manufacturers often chose to increase their best prices.

Under the best-price provision, state Medicaid agencies obtain access to the lowest prices paid for prescription drugs by any purchaser in the United States without having to duplicate the efforts of large private purchasers to earn those discounts. Many large private purchasers use a formulary--a list of drugs that doctors are encouraged to prescribe for a given illness--to guide their patients toward the most cost-effective drugs. In return for being listed on the formulary, manufacturers are sometimes willing to offer a substantial discount. However, state Medicaid programs need not adopt those practices to obtain large discounts on brand-name drugs from manufacturers. One alternative to the Medicaid rebate would be for states to adopt the practices of private purchasers and negotiate their own discounts with manufacturers. Whether the states would be able to obtain discounts as large as those that they get under the Medicaid rebate program is unclear.

The Congress is currently considering reforming the Medicaid program through block grants. Under the Balanced Budget Act of 1995, which was passed by the Congress in November but vetoed by the President, states would have had full responsibility for the Medicaid program, and federal funding would no longer have been directly linked to the level of state expenditures. The act would have preserved the Medicaid rebate program. However, the savings from the rebate program would no longer have been shared with the federal government, but rather would have belonged entirely to the states. As long as states continued to offer prescription drug benefits to their current Medicaid beneficiaries, they would probably have continued to participate in the rebate program under this reform.
 

HOW THE MEDICAID REBATE PROGRAM WORKS

Medicaid provides health care coverage primarily to low-income families with dependent children and low-income aged or disabled individuals. The federal government and the states share funding for the program. The federal share of Medicaid expenditures averages about 57 percent. The states administer the program under broad federal guidelines that allow each state to determine, within established limits, exactly who is covered, the extent of services offered, and the method of reimbursing providers. All states offer outpatient prescription drug coverage to most of their Medicaid beneficiaries, though they are not required to do so.

Pharmaceutical manufacturers must sign a rebate agreement with the Secretary of Health and Human Services in order for Medicaid to cover their products. If a manufacturer decides not to enter into a rebate agreement, then states do not receive federal Medicaid reimbursements for purchases of that company's drugs.

The manufacturer directly pays the Medicaid rebate on outpatient prescription drugs to each state Medicaid agency. All forms of the Medicaid rebate are based on the average manufacturer price (AMP) paid by wholesalers, inclusive of all discounts and price reductions "for drugs distributed to the retail pharmacy class of trade." The basic rebate ensures that Medicaid pays manufacturers no more--and sometimes less--than any private purchaser in the United States for outpatient prescription drugs.

If a brand-name drug's AMP rises faster than the inflation rate, an additional rebate is imposed so that manufacturers cannot offset the basic rebate by raising their AMP. The additional rebate is equal to the difference between the current AMP and a base-year AMP increased by the inflation rate as measured by the consumer price index.

Finally, manufacturers pay a rebate equal to 11 percent of the AMP on generic and over-the-counter drugs. To encourage states to promote substituting lower-cost generic drugs for brand-name ones, federal regulations set special reimbursement limits on 100 to 200 drugs that have generic substitutes.
 

HOW BEST-PRICE DISCOUNTS HAVE CHANGED

The Congressional Budget Office (CBO) analyzed the change in best-price discounts on more than 800 brand-name drugs purchased by Medicaid beneficiaries. In 1991, nearly one-third of the brand-name drugs still under patent (single-source drugs) had a best-price discount as high as 50 percent. But by 1994, only 9 percent of the single-source drugs had a best-price discount in that range. That change in pricing is particularly important since single-source drugs constitute over two-thirds of Medicaid reimbursements and are a major component of total U.S. expenditures on prescription drugs. (The decline in the weighted average best-price discount appears to have leveled off by 1994 as firms finished adjusting to the incentives created by the best-price provision.)

The quantity of drugs sold at the best price is not known. Therefore, the magnitude of the effect of the change in pricing on private-sector purchasers is difficult to assess. The fall in the size of the best-price discounts between 1991 and 1994 suggests that purchasers with access to those discounts have been hurt by the best-price provision of the Medicaid rebate program. The reduction in the best-price discounts between 1991 and 1994 exceeded 30 percentage points for nearly one-quarter of the drugs in the sample analyzed by CBO. Such a large percentage-point change may have affected more purchasers than just those that received the best-price discount. Any purchaser that received a discount within 30 percentage points of the best-price discount would certainly have been affected by the change in best-price discounts on those drugs.

The best-price provision increases the Medicaid rebate when a manufacturer gives a discount off the AMP that exceeds the minimum rebate of 15.1 percent. Therefore, only those private purchasers that had access to discounts in excess of 15.1 percent of the AMP would pay more as a result of the best-price provision.

Since the AMP is not public information, purchasers may not know whether their discounts are in excess of the minimum rebate. CBO calculates that the AMP is, on average, equal to about 80 percent of the published list price (also known as the average wholesale price). Hence, purchasers would have to get a discount equivalent to one-third off the list price before possibly being affected by the best-price provision.

The General Accounting Office surveyed four health maintenance organizations (HMOs) and eight hospital purchasing groups in 1990 and 1991 and found that the discounts those purchasers obtained averaged between 29 percent and 34 percent off the list price. In other words, those purchasers were, on average, getting discounts right at the threshold where the best-price provision can take effect. Some drugs that they purchased would have had discounts above that average and hence could have been affected by the best-price provision.

Several types of purchasers can obtain steep discounts from manufacturers and therefore may have been affected by the best-price provision. Those purchasers include hospitals, HMOs, clinics, nursing homes, mail-order pharmacies, and third-party payers that manage their prescription drug benefits--often with the assistance of pharmaceutical benefit management companies.
 

HOW THE MEDICAID REBATE AFFECTS PRICING

The Medicaid rebate is based on a complex pricing structure in which firms practice price discrimination by charging different prices to different types of purchasers. Price discrimination occurs in markets in which purchasers are broken into groups that vary in their sensitivity to price and suppliers have some degree of market power. Under some circumstances, price discrimination can increase both profits and total benefits to consumers. In the pharmaceutical industry, the retail sector often pays higher prices than some large institutional purchasers.

Why Best-Price Discounts Decline

In negotiating discounts with private purchasers, the manufacturers balance the decline in price on current sales against the increase in profits from the new sales that a larger discount will bring. Because Medicaid must be given access to the best price negotiated with any U.S. purchaser, the size of the rebate that would be paid to Medicaid must also be calculated as part of the cost of offering that best price to private purchasers. Since the Medicaid market is so large, the best-price provision can more than double the cost of giving discounts in excess of the minimum rebate.

The size of the Medicaid market varies widely for different drugs. CBO calculated the Medicaid market share for 89 top-selling drugs. For 20 percent of those drugs, less than 5 percent of total sales went to Medicaid beneficiaries. For 16 percent of the drugs, Medicaid's market share exceeded 20 percent. The average Medicaid market share for all drugs in the sample was 12.2 percent. The larger Medicaid's market share, the greater should be the impact of the Medicaid rebate on the pricing of a drug. Those drugs with a small Medicaid market share are more insulated from the potential effects of the best-price provision.

The effect of the Medicaid rebate on discounting also depends on the magnitude of the difference between the AMP and the best price. The best-price provision affects the pricing only of those drugs that firms wish to discount significantly to some purchasers. If the manufacturer of a drug would not offer a discount in excess of 15 percent, even if there was no Medicaid rebate, then the best-price provision would not affect the pricing of that drug. Manufacturers appear to offer larger discounts to some purchasers when many substitutes are available. In 1991, the best-price discount of brand-name drugs with no generic substitutes in CBO's sample averaged 35 percent, whereas the best-price discount of brand-name drugs that had chemically equivalent drugs on the market (usually generic) averaged 51 percent. The best-price provision probably has less effect on the pricing of highly innovative new drugs that face little competition than on the pricing of drugs that have several close substitutes.

The Medicaid Rebate and the Retail Sector

The Medicaid rebate not only affects the lowest prices charged by the manufacturer for a drug, but it could also affect the price charged to wholesalers for the retail class of trade--namely, the average manufacturer price. The minimum rebate, which is based on the AMP, would by itself create an incentive for manufacturers to raise their prices to wholesalers. However, the additional rebate does exactly the opposite--it reduces revenues on Medicaid sales when a firm raises the AMP faster than the inflation rate. The basic rebate when combined with the additional rebate does not create an incentive for firms to increase their AMP in real terms (that is, faster than the inflation rate as measured by the consumer price index for all urban consumers).

However, new drugs may be launched at a slightly higher price because of the Medicaid rebate. The larger Medicaid's anticipated share in total sales of a drug, the more important that effect is. The additional rebate is based on the increase in a drug's AMP since its first quarter on the market. Consequently, the additional rebate penalizes a pricing strategy that consists of a low introductory price followed by increases over time as the chug becomes better known. Both the minimum rebate and the additional rebate create an incentive to charge a slightly higher launch price. All things being equal, that effect implies that a drug with a significant market share anticipated for Medicaid may be launched at a slightly higher price because of the Medicaid rebate program.
 

CHANGES IN THE AVERAGE MEDICAID REBATE

Because of reduced discounts to private purchasers, the Medicaid program has not benefited as fully from the 1990 policy change as it might have. If the best-price discounts had been as high in 1994 as they were in 1991, CBO calculates, the average basic rebate paid would have been 38.6 percent rather than just 22.8 percent. But the decline of best-price discounts between 1991 and 1994, in part because of the Medicaid rebate program, was hardly a surprise to policymakers. In fact, CBO assumed a decline in best-price discounts when it originally projected the savings from the Medicaid rebate program.

Although the basic rebate was capped at 25 percent in 1991 and not capped in 1994, the best-price provision increased the average basic rebate paid by 7 to 8 percentage points of AMP in both 1991 and 1994. The decline in best-price discounts since 1991 has limited the contribution of the best-price provision to the average basic rebate. Indeed, that contribution is no higher now than it was in 1991 under the cap.
 

ALTERNATIVES TO THE BEST-PRICE PROVISION

Rather than extending their best prices to the entire Medicaid market, firms more often have chosen to raise their best prices (that is, lower their discounts). However, when that occurs, both the government and some private-sector purchasers lose. Fortunately, some alternatives exist that would reduce the impact of the best-price provision on firms' incentive to offer steep discounts without reducing the savings obtained through the Medicaid rebate program.

Modifying the best-price provision could benefit purchasers that negotiate discounts with pharmaceutical manufacturers because manufacturers would not pay as large a penalty for offering generous discounts. CBO estimates that a repeal of the best-price provision would not affect the total rebate savings in 1996 if the minimum rebate was increased from 15.1 percent to 22.6 percent. Alternatively, a cap of 50 percent on the basic rebate would be budget neutral if the minimum rebate was increased from 15.1 percent to 16.7 percent.

Another alternative is to eliminate the Medicaid rebate program and fold Medicaid beneficiaries into managed care plans that can negotiate their own discounts on outpatient drugs from manufacturers. Of course, that policy has broad implications beyond the cost and use of prescription drugs by Medicaid beneficiaries. As of the end of 1994, eight states had obtained waivers from statutory requirements from the Health Care Financing Administration allowing them to move a large portion of their Medicaid beneficiaries into managed care organizations. Most of those states have forgone the Medicaid rebates for beneficiaries enrolled in managed care organizations (or plan to). This latter option could still benefit states if the managed care organizations cover outpatient prescription drugs at a very reasonable rate based in part on their ability to negotiate their own discounts.

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