Editor's Note: This piece is co-authored by Sally C. Pipes and Wayne Winegarden.
There they go again. Free-market advocates are jeopardizing pro-market healthcare reforms based on an inability to recognize how cronyism tars the current industry dynamics. That distinction between companies operating in a free market and companies using cronyism to flourish in a government-dominated market is the key.
At question are the operations of pharmacy benefit managers (PBMs). PBMs serve large insurers, employer-sponsored health plans, and government health plans. The three largest PBMs control nearly 80% of the market and are subsidiaries of large insurers -- CVS Health/Caremark (33% of the market), Cigna/Express Scripts (24%), and UnitedHealth/OptumRx (22%).
If patients were in control of the healthcare system, then such market dynamics would not necessarily matter. But they are not. The lack of patient control combined with the opaque and complex pricing structure creates practices that harm patients. Most notably, PBMs enable a discount bait and switch that would never arise in a free and competitive market.
If this bait and switch were used in the retail industry, for instance, then customers' costs at the cash register would not change even after they presented a coupon. A $40 purchase would still cost $40. Instead of reducing shoppers' costs, the savings would be diverted to a third party that is neither the customer nor the manufacturer.
It's hard to imagine that customers would accept this model when buying clothing, food, or sporting equipment even if the third-party assured them that the discounts lowered product costs for everyone. Customers would likely resent such blatant gamesmanship and boycott any industry that tried to employ them, which is probably why this discount model does not exist in the broader retail market.
PBMs' intermediary role enables this anti-competitive practice to flourish in the market for drugs. A central function of PBMs is to negotiate discounts with drug manufacturers on behalf of insurers. PBMs have a favorable bargaining position when negotiating with manufacturers because a vibrant patient-centered healthcare system does not exist, three firms control most of the market, and PBMs essentially set the formularies (i.e., the list of drugs that patients can access).
Since PBMs earn more money when the discounts are larger, the market has been distorted to accommodate the incentives of PBMs rather than the needs of patients. To accommodate the need for large discounts, the list prices of drugs have been rising quickly. Although down from their double-digit growth rates in the early 2010s, they still grew 5.4% in 2023, according to the industry research source Drug Channels. Net prices, the systemically relevant price that includes the large discounts PBMs negotiate, have been declining for the last 6 years.
These pricing trends are significant. They mean that PBMs' profits are high because they can extract expensive fees and earn a percentage of the spread between gross and net prices. Insurers' costs are controlled because their costs are based on the less expensive net prices. Manufacturers' profits are also based on net prices -- indicating they have been consistently receiving less money for drugs over the past 6 years. Patients' costs, on the other hand, are going up because their out-of-pocket expenditures are based on the inflated gross prices.
In other words, patients are being harmed despite the existence of large discounts that keep total drug expenditures in line with the long-term trends. The retort of supporters of the current system that these costs are okay because the discounts are used to lower premiums for everyone rings hollow. Charging patients who require expensive medicines more money to lower premiums for healthy patients is both inequitable and antithetical to the principles of insurance.
Other arguments against reforming PBMs are just as specious. For instance, the claim that reforming PBMs is unnecessary because "we have paid drug manufacturers too much" makes no sense. As the gross and net pricing trends indicate, the prices received by manufacturers have been declining for years. Pharmaceutical companies' lower return on equity compared to the overall market confirms this result.
Another odd argument against PBM reform is the claim that reforms somehow stifle competition. This is the exact opposite of what will happen -- the proposed PBM reforms will remove government-created market distortions that obstruct the development of a patient-centered healthcare system.
While reforming PBMs is not a panacea, the proposals to change PBMs' practices will rein in many of the perverse incentives inflating patients' drug costs. It improves underlying market incentives and reduces the anti-patient biases that pervade the healthcare system. Unlike the claims of its detractors, reforming PBMs is a necessary pro-market healthcare reform.
Sally C. Pipes is president, CEO, and the Thomas W. Smith fellow in healthcare policy at the Pacific Research Institute. Wayne Winegarden, Ph.D. is sr. fellow in business and economics and director of the Center for Medical Economics and Innovation at the Pacific Research Institute.