How do Pharmacy Benefit Managers Determine Pricing?

This is a complex subject—first, some introductory concepts. Then, the details.

  1. In healthcare, the intersection of demand, price, quality, and suppliers’ sources alone does not determine whether pricing is appropriate.[i] Medical necessity, a complex method of determining whether a product or service should be used, is also a factor. Medical necessity is used by payors, including private insurance, Medicare, and Medicaid, to determine whether a medical procedure should be provided at all. (See Drug Pricing Legislation and Inefficient Markets Theory – No World Borders)
  2. Over ten different classification systems categorize II. Drugs, however, the National Drug Code (NDC) (see National Drug Code Directory), the Generic Product Identifier (GPI) (see Medi-Span® Generic Product Identifier (GPI)), and RxNorm used extensively for electronic prescribing are essential standards. (See, (see also RxNorm Overview)

There are three concepts that are important to understand in pharmaceutical/drug pricing. The first is the flow of physical drugs. The second is the flow of funds. The third is eligibility determination for coverage of drug costs by insurance.

  1. From a flow of drugs perspective, the drug manufacturer provides products to a wholesaler. Wholesalers sell to a pharmacy, physician, hospital, or clinic, who can sell/fulfill drugs to an insured beneficiary with a prescription from a physician or other provider such as a hospital. (See diagram from Academy of Managed Care Pharmacy).
  2. From a flow of funds perspective, Drug Manufacturers receive funds from a Wholesaler at a Weighted Average Cost or (WAC) payment subject to prompt payment and other terms. The Drug manufacturers can issue chargebacks based on inventory/stock balancing and other factors. The manufacturer may also charge a provider at a negotiated discount rebate for drugs based on volume and market share. Providers and physicians issue WAC-based payments back to wholesalers. Beneficiaries issue cost-sharing payments to providers. Health plans (payer aka insurance) issue payments at Average Selling Price, or Average Wholesale Price (AWP) or Was negotiated payments to providers as reimbursement. Beneficiaries issue payments to the health plan in the form of premiums. This flow was established decades ago.
  3. From an eligibility perspective, private insurance insureds, Medicare Part D insureds, and insureds from Medicaid (state insurance funded in part by the Federal government and distributed by states, which has different names in different states) must be deemed eligible for coverage of drug costs. Eligibility is determined based on a combination of factors. These include the diagnosis or condition of the patient and whether the drug is indicated for the patient’s diagnosis or condition. Second, the health insurance coverage plan design and formulary. A drug (whether brand name or generic) may be listed on a formulary that is identified in the health insurance plan. Third, the usual customary and reasonable price of the drug from the supplier, and fourth, whether the supplier is a contracted provider to the health plan. If not, the drug may be supplied and partially reimbursed as an out-of-network reimbursement. These issues are complex, and over time health plans have begun to contract with an outside or partly owned entity to manage this process.

Enter the Pharmacy Benefit Manager (PBM), which receives payments from health plans, and a share of rebates from manufacturers are issued back to the health plan. The Drug manufacturers issue negotiated discounts and rebates for drugs based on volume, market share, formulary placement). PBMs issue contracts to health plans, generally pricing their coverage for drugs at WAC. WAC can be used correctly, or it can be manipulated, based, for example, on last in first out (LIFO) or first in first out (FIFO) pricing. The purchase/payment lots can vary from a small volume of drugs at a high price point or the same drug purchased in a high volume at a lower price point. If PBMs contract for a LIFO-based WAC, they can buy in high volume at a low price to decrease the price point, then purchase a small amount at a high price and charge based on LIFO. This can yield artificially high profits. This is not to say that all PBMs operate in this manner. Still, the use of analytics combined with detailed knowledge of drug classification taxonomies is essential to determine if contractual arrangements are being met. Unfortunately, there is no simple answer on price determinations because PBMs use several factors in their negotiations. Here are just a few.

PBMs negotiate several provisions in contracts, including Formulary selection, Dispensing fees and discounts, Utilization management, Mail order discounts, Administrative charges, Discounts or rebate guarantees, Price protection which can affect Medicare bids and inflationary increases, Membership driven discounts to plans with more members, Rebate maximization in Medicare Part D coverage in lieu of discounts, Multi-year agreements, Tiered and select pharmacy network, Limiting days’ supply, Prior authorization, Biosimilars, and Specialty pharmacy contract provisions.

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About Michael F. Arrigo

Michael F. Arrigo is a founder of No World Borders.  The company’s first client was Advanced Medical Optics, later acquired and renamed Abbott Medical Optics, which is now part of Johnson & Johnson.  Arrigo and his team led the implementation of a solution for the medical device and pharmaceutical divisions; a pharmacovigilance complaint handling system which was implemented to comply with FDA Adverse Event Reporting requirements such as Corrective Action, Preventative Action or CAPA as provided for in 21 CFR 820.90 nonconforming product; 21 CFR 829.100 Corrective Action, Preventative Action; 21 CFR 820.198  complaint files.

[i] Pharmacy Benefit Managers Drug Pricing – No World Borders ….


Michael F. Arrigo

Michael Arrigo, an expert witness, and healthcare executive, brings four decades of experience in the software, financial services, and healthcare industries. In 2000, Mr. Arrigo founded No World Borders, a healthcare data, regulations, and economics firm with clients in the pharmaceutical, medical device, hospital, surgical center, physician group, diagnostic imaging, genetic testing, health I.T., and health insurance markets. His expertise spans the federal health programs Medicare and Medicaid and private insurance. He advises Medicare Advantage Organizations that provide health insurance under Part C of the Medicare Act. Mr. Arrigo serves as an expert witness regarding medical coding and billing, fraud damages, and electronic health record software for the U.S. Department of Justice. He has valued well over $1 billion in medical billings in personal injury liens, malpractice, and insurance fraud cases. The U.S. Court of Appeals considered Mr. Arrigo's opinion regarding loss amounts, vacating, and remanding sentencing in a fraud case. Mr. Arrigo provides expertise in the Medicare Secondary Payer Act, Medicare LCDs, anti-trust litigation, medical intellectual property and trade secrets, HIPAA privacy, health care electronic claim data Standards, physician compensation, Anti-Kickback Statute, Stark law, the Affordable Care Act, False Claims Act, and the ARRA HITECH Act. Arrigo advises investors on merger and acquisition (M&A) diligence in the healthcare industry on transactions cumulatively valued at over $1 billion. Mr. Arrigo spent over ten years in Silicon Valley software firms in roles from Product Manager to CEO. He was product manager for a leading-edge database technology joint venture that became commercialized as Microsoft SQL Server, Vice President of Marketing for a software company when it grew from under $2 million in revenue to a $50 million acquisition by a company now merged into Cincom Systems, hired by private equity investors to serve as Vice President of Marketing for a secure email software company until its acquisition and multi $million investor exit by a company now merged into Axway Software S.A. (Euronext: AXW.PA), and CEO of one of the first cloud-based billing software companies, licensing its technology to Citrix Systems (NASDAQ: CTXS). Later, before entering the healthcare industry, he joined Fortune 500 company Fidelity National Financial (NYSE: FNF) as a Vice President, overseeing eCommerce solutions for the mortgage banking industry. While serving as a Vice President at Fortune 500 company First American Financial (NYSE: FAF), he oversaw eCommerce and regulatory compliance technology initiatives for the top ten mortgage banks and led the Sarbanes Oxley Act Section 302 internal controls I.T. audit for the company, supporting Section 404 of the Sarbanes Oxley Act. Mr. Arrigo earned his Bachelor of Science in Business Administration from the University of Southern California. Before that, he studied computer science, statistics, and economics at the University of California, Irvine. His post-graduate studies include biomedical ethics at Harvard Medical School, biomedical informatics at Stanford Medical School, blockchain and crypto-economics at the Massachusetts Institute of Technology, and training as a Certified Professional Medical Auditor (CPMA). Mr. Arrigo is qualified to serve as a director due to his experience in healthcare data, regulations, and economics, his leadership roles in software and financial services public companies, and his healthcare M&A diligence and public company regulatory experience. Mr. Arrigo is quoted in The Wall Street Journal, Fortune Magazine, Kaiser Health News, Consumer Affairs, National Public Radio (NPR), NBC News Houston, USA Today / Milwaukee Journal Sentinel, Medical Economics, Capitol ForumThe Daily Beast, the Lund Report, Inside Higher Ed, New England Psychologist, and other press and media outlets. He authored a peer-reviewed article regarding clinical documentation quality to support accurate medical coding, billing, and good patient care, published by Healthcare Financial Management Association (HFMA) and published in Healthcare I.T. News. Mr. Arrigo serves as a member of the board of directors of a publicly traded company in the healthcare and data analytics industry, where his duties include: member, audit committee; chair, compensation committee; member, special committee.

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