The Pharmacy Industry's Future in an AAC World

Yesterday, I looked at the momentum behind the collection and publication of Average Acquisition Cost (AAC) data for brand and generic drugs. See Coming Soon: Average Acquisition Costs for Pharmacies.

What will happen to the pharmacy industry as these data get adopted by public and private payers? My $0.02:

• Average cost reimbursement will accelerate consolidation in the pharmacy industry.

• Bigger and/or more efficient pharmacies will get a natural advantage that doesn’t exist (or is very weak) with list-price models.

• Payers will need to evaluate the potential negative impact on generic dispensing incentives, especially as we enter the coming generic wave.

Portions of the text below are excerpted from The 2010-11 Economic Report on Retail and Specialty Pharmacies.

WHAT IS COST-PLUS?

Let's start with some definitions. As John von Neumann said: "There's no sense being exact about something if you don't even know what you're talking about."

Private and government third-party payers generally use one of three primary methods to estimate a pharmacy’s ingredient costs for a drug and compute an appropriate reimbursement amount:

• A List Price approach links reimbursement to a public price benchmark, such as Average Wholesale Price (AWP) or Wholesale Acquisition Cost (WAC). This is the most common method for brand-name and specialty prescriptions.

• A Fixed Price approach establishes a unit price limit for the ingredient cost reimbursement, such as the Maximum Allowable Cost (MAC) approach. This is the most common approach for generic prescriptions after the 180-day exclusivity period.
  

• A Cost-Plus approach computes the ingredient cost reimbursement based on: (1) sales price data collected from manufacturers, such as Average Sales Price (ASP), (2) acquisition cost data collected from pharmacies, such as Average Acquisition Cost (AAC) or (3) privately-shared cost information a la Caterpillar's arrangement with Walmart (NYSE:WMT) or Walgreens (NYSE:WAG).

The use of an external average-cost benchmark, such as AAC or ASP, is the most administratively straightforward way for a third-party payer to implement cost-plus pharmacy reimbursement.

State Medicaid programs seem willing to use the National Average Drug Acquisition Cost (NADAC) data or their own AAC surveys for pharmacy reimbursement. Once these data can be verified, I expect commercial payers and PBMs to eventually adopt public AAC information into network contracts. This is what is happening (slowly) with Average Sales Price (ASP) as a benchmark for physician office and clinic reimbursement.

Fans of drug-pricing benchmark litigation (and who isn't?) will recall that Judge Patti Saris chastised third-party payors (TPPs) for not adopting cost-plus reimbursement models for physician-administered drugs. In her June 2007 decision, she opined that third-party payors “…were not proactive in adjusting to cost data once Medicare did the legwork for them in devising more reasonable drug pricing and service fees. Medicare provided the TPPs with cover, by insulating them from protests by the network of providers.” DOH!

IMPACT OF COST-PLUS ON PHARMACIES

As I see it, average price reimbursement will accelerate consolidation in the pharmacy industry.

Why? In a list-price-based reimbursement system, a pharmacy that purchases at a lower acquisition price will have a higher spread and higher gross profits than a pharmacy buying at a higher acquisition price. In an average price system, the pharmacy that buys at a lower price also brings down the computed market average, creating a further disadvantage for smaller buyers.

If cost-plus models become more common, the pharmacies with a combination of below-average operating expenses and below-average acquisition costs would become the best positioned to succeed.

The self-warehousing chains and mail-order pharmacies would have a natural advantage, since these companies are able to acquire drugs less expensively. Thus, a combined Express Scripts (NASDAQ:ESRX)-Medco Health Solutions (NYSE:MHS) organization will be a big winner in a cost-plus world per ESRX-MHS: Strategic and Market Analysis. Larger, more active stores would also benefit from cost-plus contracting, because they have the lowest average costs of dispensing.

THE DOWNSIDE OF COST-PLUS

The widespread adoption of cost-plus models faces at least one significant hurdle: These models limit the profitability of generic drugs for pharmacies. Overall system costs could increase if the incentives for generic substitution by pharmacies, PBMs, and drug wholesalers are diminished.

Generic substitution is one of the most reliable and consistent means for a payer to reduce expenditures for a prescription-drug plan. Cost-plus primarily limits the potential profitability of generic drugs, thereby reducing incentives for the channel to negotiate vigorously with generic manufacturers. Cost-plus reimbursement could also reduce incentives to lower operating costs, since a pharmacy would increase total gross profit dollars when paid a margin above a higher cost basis.

Payers must therefore consider a complex question before adopting cost-plus reimbursement: At what level of drug channel profits could they still encourage rapid generic substitution while not “overpaying” for generics?

The OIG seems oblivious to this issue, as I point out in my critique of their study on generic injectables. See Profits from Generic Injectables: Too High or Just Right? Pharmacies should be heartened that CMS is sympathetic to the incentive issue, noted in CMS’ comments on the OIG report.

This whole conversation gets even more intriguing as the generic wave ends and competition reduces margins on mature generic drugs. See What's Behind Teva's Cephalon Deal for a pretty picture of the coming generic boom-to-bust cycle.