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Why do medications cost so much, particularly specialty drugs that treat the most serious conditions? Mostly because U.S. drug companies can price them however they want. Some of their justifications are reasonable — for instance, high prices fund research. Others, like the notion that drug treatment lowers total medical costs, are far from proven.

But pharmaceutical companies don’t deserve all of the blame for high drug prices. Lots of other actors in purchasing, distribution, and brokerage have greater incentives to keep prices high than to lower prices or choose drugs that reduce longer-term medical and business costs, like absenteeism.

We believe that employers have the greatest potential to influence some of those actors and, ultimately, to chip away at high drug prices. To appreciate the power that employers have in this area, you must first understand how competing incentives work in the world of drug pricing.

Competing Incentives

Hospitals, for example, can take advantage of the 340B pricing program, which allows them to buy drugs at 30% to 50% of the retail price but then bill at full price for patients with insurance. And even organizations that, theoretically, are paid to help hold down drug costs sometimes have incentives to do the opposite. Take insurers and pharmacy benefit managers (PBMs), which are hired to manage drug costs for employer-based health plans.

Indeed, it’s smart for employers like GE, IBM, and Google to contract with these specialist entities and have them decide which drug among several competitors their employees should get first, at what cost, and which medical policies should govern the use of that drug. After all, insurers and PBMs can spread the costs for research, negotiation, and decision making about drug-reimbursement policies across all of their clients.

However, PBMs and insurers may have business objectives that differ from those of their clients. For one, they’re not always at risk for the cost of drugs — the clients are. Also, a PBM or a pharmacy department of an insurer gets a substantial portion of its drug-related profit from rebates. These are payments negotiated with manufacturers that return, via the PBM or payer intermediary, a percentage of the drug’s price to the payer — for example, to an employer that contracts with a PBM or an insurer.

Here’s a simplified version of how these rebates work:

To get the business, the PBM or plan typically guarantees a minimum rebate on every prescription, say $60. On a $300 script, that’s a 20% net reduction in the cost to the employer (final price: $240). As an incentive for the PBM or plan to negotiate even harder — maybe get a 30% rebate (in this case, another $30) — it often takes home 30% to 50% of anything above the guaranteed rebate. In this example, if the split were 50/50, the employer would pay $225, net, for the prescription and the PBM would get $15. Not a bad deal.

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In the old days — maybe five years ago, when most prescriptions ranged from $200 to $400 — rebates worked to the employer’s advantage. But for a specialty drug, costing say $50,000, a rebate of 20% means that the employer pays a net $40,000 and the PBM pockets $10,000 (plus other fees for processing and, sometimes, for handling the prescription through a specialty pharmacy division). Meanwhile, the $60 guarantee becomes meaningless.

Now let’s assume both a smaller rebate (10%) and a lower price ($25,000) for the same drug. The $60 rebate is still meaningless, but now the net cost to the employer is $22,500 (much better than $40,000) and the PBM’s profit is just $2,500. If you’re the PBM, do you want the manufacturer to price the drug at $50,000 or $25,000?

It’s also true that very large employers sometimes get virtually the whole rebate, not a 50/50 split. But don’t cry for the plans and PBMs, which know how to tack on various fees, often including a specialty pharmacy fee of about 2%. That cost covers the overhead and profit margin of a necessary part of the distribution system. But 2% on a $500 drug is $10; on a $50,000 drug, it’s $1,000. Again, a higher drug price means a more profitable supply chain.

(Insurance companies would argue, by the way, that they shouldn’t be lumped in completely with PBMs, because most insurers manage their pass-through and full-risk businesses with the same pharmacy policies. For the full-risk business, insurers care about drug prices, at least to the extent that they can’t just raise premiums for employers.)

Options for Lowering Prices

The easiest way to lower drug prices would be with a single-payer system, which most European countries have. That payer would be on the hook for all medical costs and would therefore have the incentives — and the clout — to negotiate lower prices. But we can’t envision that happening in the U.S., where some political players would cry “socialism.” So we’re left looking to employers and the Centers for Medicare and Medicaid Services (CMS), which runs Medicare.

Changing CMS reimbursement practices is a Sisyphean task, given the congressional and lobbyist opponents. Even a relatively small proposal last year — narrowing the “protected classes” rules that, in essence, require reimbursement for all drugs in six therapeutic areas — was shot down decisively by drug companies, patient advocacy groups, and legislators.

Employers’ weak-kneed behavior is more baffling — no other group has a greater stake in buying smarter. But employers have always been reluctant actors in the health care system, as they feel out of their depth. Some companies, like Honeywell and Nielsen, have taken tough steps to control costs, with no loss in employee satisfaction. But don’t count on a sea change in employer buying behavior — when push comes to shove, they can always shift costs to their employees.

What Employers Can Do

Employers must recognize that, like it or not, the buck stops with them. Patients can hardly negotiate for themselves, but employers can be much more aggressive in getting PBMs and payers to have skin in the drug-pricing game.

Our sense is that PBMs, at least, are willing to listen. Express Scripts, for example, recently proposed capping its customers’ total exposure to the PCSK9-inhibitor class of cholesterol-lowering drugs. If their customers spend more than a pre-set amount, Express Scripts eats the overage. Certainly, Express wouldn’t do this without a clear idea of how much its clients would be spending. Notably, those clients must agree to follow Express’s rules about who gets the expensive drugs — and must use Express’s specialty pharmacy. But it’s a very good start.

We certainly don’t expect employers to start writing drug-coverage policies and doing their own contracting. But, as seasoned buyers, they know how to negotiate with suppliers, such as insurers and PBMs — and they should not be afraid to do it. It’s now easier to understand the tradeoffs among competitive drugs, thanks to tools like the Institute for Clinical and Economic Review’s new assessment reports, RealEndpoints’ RxScorecard, and the National Comprehensive Cancer Network’s evidence blocks.

Combine these tools with contracting that does not focus entirely on rebates, and employers may begin to change the rules of a game they will otherwise continue to lose.

by Robert Galvin, MD and Roger Longman