Don't trust the middleman: pharmacy benefits managers can exploit their position at the center of a complex drug-delivery system to rip off consumers.

As prices for prescription drugs have skyrocketed, pharmaceutical companies have been taken to court for allegedly fixing prices, suppressing generic competition, and abusing Medicare and Medicaid regulations--to the detriment of consumers, states, and the federal government. But other, relatively unknown players in the pricing and distribution of drugs are also harming consumers.

Pharmacy benefits managers (PBMs) administer prescription drug benefit programs for employers, unions, health plans, and other groups. They act as intermediaries tot roughly 11,000 third-party payers and make decisions regarding drug delivery that affect over 276 million consumers. (1)

PBMs play a major role in the drug-delivery system, but their business practices are increasingly questionable. In litigation emerging across the country, plaintiffs are challenging these practices and seeking compensation for harm to health plan participants.

The pharmaceutical industry is a complex group of entities: ones that manufacture drugs, ones that deliver drugs from manufacturers to consumers, and ones that reimburse consumers and their health plans. Because so many parties are involved, pharmaceutical transactions generally lack the transparency of those in other markets and industries. Standard economic data, such as actual drug prices, is either unclear or simply unavailable. In this environment, PBMs--which possess considerable market power and control drug-cost information--can easily perpetrate fraudulent pricing and other unlawful schemes.

PBMs were created as brokers between health insurers and drug manufacturers to help control drug costs and coverage. As prescription drug prices and choices have increased, health plans have contracted with PBMs to handle drug purchasing and distribution for them. A large PBM may have many separate health plans as its clients. Today, the big four PBMs--Medco, AdvancePCS, Express Scripts, and Caremark RX, Inc.--control the prescription drug benefits of about 210 million people in the United States, about 70 percent of the nation's population. (2)

Traditionally, PBMs were paid administrative tees for managing prescriptions, acting as fiduciaries for health plans with the mission of providing lower drug costs for the plans and their participants. In recent years, however, PBMs have deviated from their original mission and transformed themselves into profit-sharing players in the prescription drug industry. To mask this change, they often refuse to reveal their increasing revenues to the health plans they purport to act for.

In a typical arrangement, a health plan contracts with a PBM to manage the plan members' prescription drug benefits. The PBM, in turn, contracts with a network of retail pharmacies to fill prescriptions. The pharmacies buy drugs from wholesalers at the average wholesale price (AWP) and receive a dispensing fee from the health plan; the PBM takes a portion of the AWP as a fee for its services. PBMs may also buy drugs from manufacturers, usually receiving a bulk-order rebate, to sell directly to plan members through their own mail-order pharmacies, keeping some or all of the rebate, the dispensing fees, and their share of the spread between the AWP and their cost.

In such a complex system, it's difficult to follow the money. Generally, PBMs pay

* health plans a percentage of manufacturers' rebates

* pharmacies for the wholesale cost of the prescription drug (less the patient's small copayment)

* manufacturers for drugs that PBMs dispense through their own pharmacy divisions.

PBMs collect money (in rebates and fees) from

* health plans for managing member benefits

* manufacturers as rebates for placing drugs on the PBM's formulary (its list of preferred medicines)

* pharmacies, in that they give price discounts to PBM enrollees. (3)

In addition to managing and paying prescription drug claims, PBMs review patients' drug use to prevent drug interactions, provide disease-management services, and directly encourage pharmacists and physicians to use low-cost alternatives, particularly generics. Large PBMs can spread the fixed costs of such activities over many transactions, increasing cost efficiency.

As a group, PBMs dominate the flow of reimbursements for pharmaceuticals, and their economic influence is great. Given their ability to affect a drug's market share, they have considerable leverage to negotiate rebates with drug manufacturers. This leverage comes, in part, from PBMs' use of formularies. PBMs can exclude certain drugs from their formularies or encourage enrollees to choose a particular drug from a group of therapeutic substitutes. The manufacturers' rebates are often computed based on the number of purchases channeled through the PBM.

Because of their relationships with many different parties in the drug-delivery system, PBMs have access to information--health plan reimbursements, actual drug prices, pharmacy incentives--that they can exploit to their own financial advantage and to the detriment of the health plans and their participants.

Profit-taking schemes

Undisclosed rebates. Drug manufacturers typically pay a PBM an "access" rebate to place products on its formulary, "market share" rebates for exceeding established sales targets, administrative fees for assembling data to verify market-share results, and other fees and grants. Although PBMs typically agree to share rebates with their health plan clients, they often retain all or most of the rebates by, for example, reporting the lump sum of what the PBM saved a health plan without breaking out rebates. This makes unclear whether the rebates are being shared or the savings are coming from the PBM's formulary selections. PBMs may also refuse to disclose to client health plans the amount of specific rebates they receive, instead providing only aggregate amounts. This prevents a health plan from learning the true amount of rebates the PBM has received for handling the drug benefits of the plan members.

Spreads. For brand-name drugs, PBMs use inflated AWPs, which the manufacturers set, as the basis for reimbursements--both from health plans to PBMs and from PBMs to pharmacies for plan members' drug purchases.

PBMs typically contract with retail pharmacies to pay them an amount equal to each drug's AWP, less a specified discount, plus a dispensing fee. Because PBMs consider these contracts confidential, health plans do not know what their PBM pays pharmacies to fill plan participants' prescriptions. Without such disclosures, PBMs can pocket a "spread"--the difference between what they pay pharmacies and what they collect from health plans. For example, PBMs may charge health plan clients AWP minus 13 percent, but pay the pharmacy AWP minus 15 percent, generating an undisclosed 2 percent spread for the PBM.

PBMs are much more likely to place drugs with inflated AWPs on their formularies, because the greater the price, the greater the profit generated by the 2 percent spread. The Wall Street Journal reported one example: AdvancePCS charged a state health plan $18.39 for a generic version of the painkiller Propoxy. It paid the pharmacy $13.32 and kept $5.07--for a 38 percent profit. (4) AdvancePCS had agreed to pass through pharmacy prices without a markup.

For mail-order prescriptions, PBMs receive the entire spread between the manufacturer's AWP and the actual cost because there is no intermediary retail pharmacy to share the spread.

Mail-order abuses. PBMs profit from mail-order prescriptions because they get bulk-purchase discounts from drug manufacturers. Although they may disclose this margin to their health plans, PBMs may not reveal that their mail-order divisions also commonly receive a prompt-payment discount--usually 2 percent of the AWP--that is rarely passed along to clients.

PBMs also use mail-order delivery to induce patients to switch to higher-cost alternatives. They do this by filling mail-order prescriptions with brand-name drugs, even though less-expensive generics may be available.

For example, suppose a patient presents a prescription for a brand-name drug that has a generic equivalent (known as a multisource drug). And suppose there is another brand-name drug with no generic equivalent (a single-source drug) that is a close substitute. The manufacturer of the multisource drug does not offer the PBM a rebate; the manufacturer of the single-source drug does. The per-unit list price or AWP of the single-source drug is usually more than the list prices of the multisource drug and its generic equivalents. Thus, a PBM with its own mail-order division will earn significantly more money selling the single-source drug, even when it puts a higher percentage markup on the generic product. (PBMs encourage the use of generics, because they can make considerable sums on the substantial spread between reported AWP and actual average sale price.) (5)

Repackaging. PBMs with their own mail-order divisions also have an incentive to repackage the drugs they dispense, charging health plans higher AWPs than the manufacturers originally set. Pharmacies buy drugs in bulk from the manufacturers and "repackage" them by changing the container, wrapper, or labeling.

Repackaging is typically done to meet specific needs, particularly for institutions. For instance, hospitals that dispense large quantities of drugs in pill form commonly require the medication to be repackaged in "blister" packs. A PBM can repackage and reprice because the FDA assigns a repackaged product its own, separate national drug code--which identifies the labeler/ vendor, product, and package size. A PBM mail-order division still provides a bigger discount than a retail pharmacy, but consumers pay a higher price on mail orders because of the AWP markup.

Suppose a PBM negotiates with pharmacies on behalf of its health plan clients for a retail price of the AWP minus 10 percent, plus a $3 dispensing fee. As an example, consider Celebrex. The manufacturer's AWP is $105.34 for a 60-day supply ($1.76 per day). The health plan would pay the pharmacy $97.81 to fill the prescription ($94.81, plus a $3 dispensing fee). The PBM might offer the plan a "better" deal on mail orders to encourage its members to use the service. For instance, it might offer to fill mail-order prescriptions at the AWP minus 25 percent.

However, if the PBM has inflated the AWP of its repackaged Celebrex, it can fulfill the literal terms of its contract and still make more money. The mail-order division can set its AWP at $186.13 for a 60-day supply ($3.10 per day), as one PBM has done for Celebrex. Then, even with a 23 percent discount, the PBM sells the product to health plan members for a net price of $142.60 ($139.60 pins $3), which amounts to $47.79 more than the plan would have paid the independent pharmacy. The PBM pockets this amount, minus the relatively low cost of repackaging.

Litigation

In general, PBM litigation is in its infancy, but PBMs' abusive business practices provide grounds for actions by health plans, consumers, and state attorneys general. Three cases offer an overview.

* A trustee for the Health and Welfare Fund of the New York City Patrolmen's Benevolent Association sued the National Prescription Administration (NPA), asserting that it took advantage of pricing spreads, took rebates and other kickbacks, received payment for formulary placement, and used higher-price drugs when lower-cost equivalents were available. (6) The suit claims breach of fiduciary duty, and seeks an accounting of the rebate due to the plan under the Employee Retirement Income Security Act (ERISA), which governs the health plan.

* The American Federation of State, County and Municipal Employees sued the four major PBMs on behalf of all non-ERISA health plans in California. (7) The suit uses California's powerful unfair-competition law to attack the PBM practices outlined in the case against NPA. It seeks recovery of rebates and fees taken by the PBMs but not disclosed to health plans; damages for consumers who paid for higher-price drugs; and damages for the spreads the PBMs took in their dealings with pharmacies.

* New York Attorney General Eliot Spitzer sued Express Scripts on behalf of Empire Plan, the state's employee health plan, after a yearlong investigation. (8) The lawsuit alleges that Express Scripts inflated generic-drug costs; kept millions of dollars in manufacturer rebates; used fraud to induce physicians to switch patients' prescriptions to drugs for which Express Scripts received money from the manufacturer; sold and licensed Empire Plan data to drug manufacturers, data collection services, and others without the plan's permission; and misrepresented the discounts Empire Plan received for drugs purchased at retail pharmacies.

There is little question that the complexity and lack of transparency in drug purchasing and delivery have allowed PBMs to enrich themselves. PBMs that receive rebates, market-share fees, or other inducements from manufacturers harm health plans and consumers, who end up paying higher costs for prescription drugs. Legal action on their behalf can provide a remedy.

Notes

(1.) Tutorial, Dr. Meredith Rosenthal, In re Pharmaceutical Industry Average Wholesale Price Litig., MDL No. 1456 (D. Mass. filed Dec. 6, 2004).

(2.) Id. at 14-15.

(3.) For an overview of the PBM industry, see ROBIN J. STRONGIN, NAT'L HEALTH POLICY FORUM, THE ABCs OF PBMs, ISSUE BRIEF NO. 749 (Oct. 27, 1999).

(4.) Barbara Martinez, Rx for Margins: Hired to Cut Costs, Firms Find Profits in Generic Drugs, WALL ST. J., Mar. 31, 2003, at A1.

(5.) Id.

(6.) Lynch v Nat'l Prescription Admin., No. 03CV-1303 (S.D.N.Y. filed Feb. 26, 2003).

(7.) Am. Fed'n of State, County & Mun. Employees v. Advance Caremark, No. BC292227 (Cal., Los Angeles Super. Ct. filed Mar. 17, 2003).

(8.) New York v. Express Scripts, No. 0004669/2004 (N.Y., N.Y. County Sup. Ct. filed Oct. 6, 2004).

STEVE W. BERMAN is the managing partner of Hagens Berman Sobol Shapiro, which has offices in Cambridge, Massachusetts; Chicago; Los Angeles; Phoenix; and Seattle. THOMAS SOBOL is the managing partner of the Cambridge office.