Some aspects of the U.S. health care system might seem simple enough. When a patient is sick, the patient goes to see a provider. The provider prescribes the patient a prescription drug and the patient picks up the prescription at a pharmacy. Seems simple, right?

But there's a lot more going on behind the scenes between drug manufacturers, insurers, pharmacies, and, specifically, pharmacy benefit managers (PBMs). You've probably heard of PBMs before. PBMs rose to prominence as the nation's attention turned toward rising prescription drug prices and scandals broke out over the cost of Mylan's EpiPen and Turing Pharmaceuticals' Daraprim (think Martin Shkreli).

Amid the controversy, PBMs often emerged as the "scapegoat" for prescription drug price increases. In particular, executives of drug companies claimed prescription drug prices have increased because of a flawed pharmaceutical supply chain, which encourages drugmakers to raise list prices of drugs in order to offset the cost of paying rebates to PBMs.

To get a better understanding of how rebates are affecting drug prices, the House recently passed two bills— the Public Disclosure of Drug Discounts Act (HR 2115) and the Payment Commission Data Act of 2019 (HR 1781)—that would increase transparency around the rebates drugmakers offer PBMs.

But there's more to PBMs than rebates. Read this post to get an overview of the role PBMs play in the pharmaceutical supply chain and then sign up for a 30-minute webconference to learn more much more about how PBMs operate.

Where do PBMs fit in the pharmaceutical supply chain?

PBMs entered the market in the 1960s to meet the needs of the employer-based health benefit market, and today they function at the center of the pharmaceutical supply chain, acting as intermediaries between insurers, drug manufacturers, and pharmacies.

Collectively, the three largest PBMs have 76% market share. The top three PBMs by market share are:

• CVS Caremark, which manages 30% of the market;
• Express Scripts, which manages 23% of the market; and
• Optum Rx*, which manages 23% of the market.

(Daily Briefing is published by Advisory Board, a subsidiary of Optum).

But what exactly do these PBMs do? The simple answer is a lot.

PBMs are responsible for processing approximately two-thirds of the 6 billion prescriptions written by U.S. providers annually. That's because private and public insurers hire PBMs to handle drug benefits for their health plans. As part of that, PBMs develop lists—or formularies—of the drugs covered by a health insurer and negotiate rebates and discounts for prescription drugs on behalf of them. This means PBMs are involved in determining how much insurers pay manufacturers for a drug and how much consumers pay at the pharmacy counter.

PBMs’ central role in the drug supply chain also enables them to establish pharmacy networks, play a role in negotiating reimbursement rates, and implement clinical care management programs.

How do PBMs generate revenue?

PBMs used to largely generate revenue through charging administrative or service fees within their contracts with private health plans. However, in recent years, they've sought a number of ways to diversify their revenue.

One way is through government contracts, specifically Medicare Part D plan sponsors and Medicaid managed care programs. In 2016, PBMs were in charge of 74% of drug benefit management services for Medicare Part D. In 2017, PBMs managed pharmacy benefits for 38 million Medicaid managed care enrollees.

Another source of revenue for PBMs, and one of the most controversial, are rebates from manufacturers. Manufacturers provide rebates to promote use of their drugs, and will offer them to achieve "preferred" formulary status or other benefits from the PBM. Manufacturers typically offer higher rebates for brand products in therapeutic classes with competing products, such as diabetes medications.

For example, a drug manufacturer like Eli Lilly would offer a PBM a 66% discount off of its short-acting insulin Humalog, bringing down the list price of the Humalog cartridges from $29.36 to $10.06. Under a traditional rebate model, Humalog would cost PBMs $10.06. If the PBM passes on 91% of the rebate, then health plan sponsors would see 60% of the savings off Humalog's list price—or $11.80 per cartridge. And PBMs would generate a profit of $1.74 per each Humalog cartridge bought by the insurer.

Therefore, PBMs can often negotiate and pass on significant savings to plan sponsors. But just how much revenue PBMs keep from these rebates has become a source of debate. One estimate suggests PBMs pass on 91% of rebates to commercial plans (up from 75% in 2012). And a recent report from the Government Accountability Office found PBMs in 2016 passed on 99.6% of the $18 billion in rebates negotiated with drugmakers for Part D drugs to insurers and only retained 0.4%.

PBMs have generally been passing on more of their rebates to sponsors in recent years and note that their reliance on rebates as a revenue source is decreasing. However, critics argue that the rebate model can inflate drug prices as health plans generally evaluate PBMs on these rebate guarantees rather than net drug spend. As a result, PBMs may be incentivized to negotiate for higher rebates as opposed to lower costs. At the same time, drug manufacturers claim that the growing rebates they pay PBMs force them to raise list prices on drugs.

There are also concerns that PBMs, even as their rebate pass-through percentages have been increasing, have been getting fees from manufacturers that are not strictly called "rebates," but that still function as de-facto rebates. These fees can obscure plan sponsor's understanding of the actual rebates they are getting.

Additionally, in some cases, a PBM will charge insurers more for a drug than the PBM pays a pharmacy to dispense it and the PBM will keep the difference instead of passing on the full payment to pharmacies.

This practice, which is called spread pricing, is expected in traditional plan contracts, but the extent of the spread taken is rarely transparent and therefore often a source of controversy. CMS recently released regulatory guidance to crack down on the practice. To understand spread pricing, let's look at an example. A PBM could bill a health system $26.87 for a single five-day generic antibiotic prescription and pay an in-house retail pharmacy only $5.19, which means the PBM generated a spread of $21.68 from an employee's prescription. PBMs mostly take spread pricing on generic drugs.

PBMs also generate revenues from the direct and indirect remuneration fees (DIR) fees pharmacies pay, which include charges pharmacies pay to participate in a PBM's preferred network.

There are also several new revenue streams emerging for PBMs. For example, more PBMs are owning specialty pharmacies that can dispense specialty medications, which often are more profitable. PBMs often restrict where health plan members can fill their specialty prescriptions by requiring them to fill their prescriptions at PBM-owned specialty pharmacies. In the past few years, specialty pharmacies have represented a larger share of the revenue generated by PBMs, a trend which is expected to grow.

In addition, vertical integration within the market, like the health insurer Cigna's acquisition of the PBM Express Scripts or CVS Health's acquisition of Aetna, is providing PBMs with more opportunities to generate revenue.

How do PBMs interact with health systems?

Health systems often have a unique opportunity as both health plan sponsors and providers to work with PBMs, and can often employ their expertise and resources in beneficial ways. 

For instance, pharmacy leaders can collaborate with the benefits team during negotiations with PBMs and play a crucial role. At one large AMC in the South, pharmacy leaders have attended nearly all of the organization's meetings with the health system's PBM. During a recent meeting, the pharmacy leaders explained why the PBM's copay accumulator program, which aims to manage usage by excluding copay assistance from a patient's deductible and out-of-pocket maximum, would not benefit the health system as it might affect patient adherence.

They can also improve formulary value by removing high-cost drugs and aligning formularies across settings. At a large nonprofit system in the South, the pharmacy team was able to review the PBMs' claims to identify possible opportunities for cost savings. The VP of Pharmacy found providers had written a high number of prescriptions for a brand-name ointment. When she told providers about the generic version of the treatment, they system saw a decline in the number of brand-name prescriptions written and saved the hundreds of dollars per prescription.