CAT + WAG = More Momentum for Cost Plus

What is Caterpillar smokin’? It must be strong because the company is trying hard to transform the economic reality of the pharmacy industry.

Two weeks ago, Walgreens announced a direct-to-payer agreement with Caterpillar that would use a cost-plus pricing model for prescriptions filled at Walgreens’ pharmacies starting in January 2010. See Walgreen to Provide Prescription Drugs for Caterpillar Workers.

This deal provides further momentum for cost-plus pharmacy reimbursement. Maybe the industry is falling down the rabbit hole into a fantasy world…or maybe the future is arriving sooner than expected. Here’s my take on what direct-to-payer, cost-plus deals could mean for drug channels along with some cautionary words on the longer-term impact.


A HOOKAH SMOKING CATERPILLAR HAS GIVEN YOU THE CALL

As you may recall, Caterpillar and Walmart launched the first major private experiment with cost-plus reimbursement in September 2008. (See WMT + CAT: Pharmacy's Future?). Caterpillar established a direct contract with Walmart for the prices of certain generic drugs dispensed at a Walmart pharmacy. This arrangement is a “direct-to-payer” approach because the pharmacy provider (Walmart) is contracting on pharmacy reimbursement directly with the third-party payer rather than using an intermediary (such as a pharmacy benefit manager).

Caterpillar has extended its relationship with Walmart and now added Walgreens to the network. I had correctly speculated that Walgreens was planning a similar direct-to-payer back in early May in Is Walgreens planning a direct-to-payer deal?, although I did not know when it would happen.

(Did you pick up on my secret for great forecasting? Predict an outcome or a date, but never both! Shhhh, don’t tell.)

ONE PILL MAKES YOU LARGER

Here are some implications of direct-to-payer, cost-plus deals such as the Caterpillar-Walmart-Walgreens relationship:

• Cost-plus is a channel compensation tool. A cost-plus model unbundles product price (revenues to the manufacturer) from the costs of distribution and dispensing (revenues to pharmacies, wholesalers, PBMs, and providers). In other words, the payer is defining a specific value for the distribution and pharmacy dispensing of drugs instead of bundling the drug cost and channel value together in a reimbursement payment. Isn't this what pharmacies have always wanted? Yes, but...
• Pharmacy margins will decline. Interest in cost-plus models stems in part from the perception by payers that current reimbursement models can provide inappropriately high pharmacy profits on certain prescriptions. Walmart claims that their cost-plus model saves employers 30% to 35% on generic drug costs along with some (unspecified) savings on brand-name drugs. (source)
• Cost-plus models are a lower risk/lower return model for pharmacies. Current reimbursement models, whether based on a list price or a payer-determined maximum allowable cost (MAC), allow pharmacies to earn positive gross margins on prescriptions *on average.* Sometimes a pharmacy can earn a very high margin on a prescription, but sometimes a pharmacy earns a low margin or even loses money. Cost-plus trades this volatility for a lower average margin but less variability, i.e., lower risk and lower return.
• Pharmacies do not become PBMs. Direct-to-payer contracting explicitly removes the PBM from the retail pharmacy pricing negotiation but does not make Walmart or Walgreens into a PBM. RESTAT, Caterpillar’s PBM, continues to perform claims adjudication, rebate negotiation, pharmacy network management, and other PBM services. As far as I know, RESTAT does not earn a spread on prescriptions filled within the retail network and passes all rebates back to Caterpillar, so there are fewer business issues compared to a traditional PBM business arrangement.
• Efficient pharmacies win. As cost-plus models become more common, pharmacies with a combination of lower-than-average operating expenses and below-average acquisition costs will be better positioned to offer these arrangements. For instance, the large self-warehousing pharmacies will have a natural advantage with cost-plus since these companies are able to acquire drugs less expensively and have a lower cost of dispensing.
• More cost-plus deals are on the way. Walmart claims to have signed more direct-to-payer deals, but has chosen not to announce their names. (Hmmm....) Walgreens will surely follow-up the CAT deal with others. Meanwhile, RESTAT recently said that it "is now working on its own version of the Caterpillar model, which it hopes to bring to customers later this year." (source)

AND ONE PILL MAKES YOU SMALLER

Could cost-plus become a self-defeating strategy for payers?

Today, generic substitution is one of the most reliable and consistent ways for a payer to reduce expenditures for a prescription drug plan. The superior profitability of generic drugs for the channel creates powerful incentives for accelerated generic substitution rates. Drug makers have been forced to give up on "end of life cycle" planning in a world when 95% of mail prescriptions switch to the generic within one week of launch. Ouch.

However, overall system costs could increase if the incentives for generic substitution (by pharmacies, PBMs, and wholesalers) are diminished. Cost-plus limits the potential profitability of generic drugs and reduces incentives for the channel to play hard ball in negotiations with generic manufacturers.

In other words, the widespread adoption of cost-plus models could ultimately slow generic substitution by making the pharmacy industry get paid like a public utility.

Yes, I realize that we're a long way from that outcome. But it suggests at least one reason why many payers will not rush to imitate Caterpillar, especially with so much money at stake. Nearly $100 billion of current branded product revenues will be lost to generic competition over the next six years.

Thus, the more challenging question for payers who are considering cost-plus is complex: At what level of drug channel profits could payers still encourage rapid generic substitution while not “overpaying” for generics?

Perhaps this is what the Jefferson Airplane meant by “when logic and proportion have fallen sloppy dead” in White Rabbit, their classic song about pharmacy reimbursement strategies. I'll go ask Alice and get back to you.