Generic Drug Profits: Too High or Appropriate Incentive?

A new OIG report highlights supposed “excess” payments by Medicare’s cost-plus drug reimbursement model, giving us a peek at the time path of generic margins in the Part B program. However, OIG overstates their case by ignoring the powerful incentives for rapid generic substitution that are created by higher profits early in the generic life cycle.

Pay attention to this report because it illustrates the generic drug profit dynamics that exist elsewhere in healthcare – retail pharmacies, providers, wholesalers, and PBM mail order. And as generic utilization rates will move toward 75 percent over the next few years, I expect that pharmacy channel margins on generic drugs will be increasingly seen as a mechanism by which payors can manage their drug trend.

As always, I encourage you to read the full report, available for download here: Medicare Payment For Irinotecan.

A Peek at Cost-Plus Reimbursement

The OIG looked at prices and reimbursement for Pfizer’s Camptosar (irinotecan hydrochloride) after the launch of nine competing generics on February 20, 2008. In the first month after generic launch (March 2008), the generics were priced at about one-third of the brand price and captured about 86 percent of sales.

Since Medicare pays for irinotecan through the Part B program, provider reimbursement is calculated using the Average Sales Price (ASP) plus five percent. I refer to the Part B approach as “cost plus” reimbursement in contrast to the “list minus” reimbursement models typically used for retail pharmacy. In a cost-plus model, the total margin dollars available to the drug channel are capped at a percentage of the manufacturer’s actual sales price.

Drug Channel Life Cycle Economics

The OIG report highlights the profit opportunity for providers and wholesalers created by the two-quarter time lag between the calculation of the cost-plus reimbursement benchmark and the actual acquisition cost.

Here’s a simple illustration using fictional data inspired by the OIG-reported figures: (Click to enlarge.)
In my example, average per-unit margin dollars between manufacturer and patient ultimately fall to $2.55, but not before spiking up from $6.25 to $80.25 (1200 percent). Since ASP is a weighted average of brand and generic prices, my example actually understates the profit potential for a provider that immediately substitutes the generic version.

Why? The Medicare Part B payment amount does not include the generic versions in price calculations until the third quarter of 2008 (beginning July 1, 2008). Since the generic came out in the middle of Q1:2008, the full price impact does not get reflected until Q4:2008.

Cost-plus reimbursement models, such as the ASP-based approach used in Medicare Part B, use market prices to dictate the pace of decline. In contrast, retail pharmacy margins can get compressed earlier in the cycle through maximum allowable cost (MAC) limits set by payors.

Getting Incentives Right

As I see it, the superior profitability of generic drugs for the drug channel has dramatically accelerated generic substitution rates during the past ten years. Check out the page 10 of Medco’s most recent Drug Trend Report, which shows Ambien (zolpidem) gaining 97% share of mail scripts and 79% of retail scripts with seven days of launch.

While brand manufacturers may not like to see these figures, private payors recognize that rapid generic substitution is crucially important for lowering their drug trend. Pharmacies, providers, PBMs, and wholesalers are all racing the clock against the expected reimbursement decline for generics.

Alas, OIG seems to miss this essential point. If Medicare completely eliminated the profit opportunity from generics (under Part B or otherwise), costs would likely increase because generic substitution would slow down. On the other hand, the big profits in 2008:Q2 raise eyebrows.

Thus, the real question that OIG and Medicare should ask is more complex: At what level of drug channel profits could payors still encourage rapid generic substitution while not “overpaying” for generics? Understanding how payors will answer this question will help predict the future profit streams of pharmacies, wholesalers, and PBMs.