Pharmacy Benefit Managers

Pharmacy Benefit Managers

Order Code RL30754
CRS Report for Congress
Received through the CRS Web
Pharmacy Benefit Managers
November 29, 2000
Christopher J. Sroka
Economic Analyst
Resources, Science, and Industry Division
Congressional Research Service ˜ The Library of Congress

Pharmacy Benefit Managers
Summary
The provision of prescription drug coverage to Medicare beneficiaries was a
major issue in the 106th Congress, and is likely to continue to be a major issue in the
107th Congress. Much attention is being focused on this issue because of reports
about the financial burden that prescription drug prices place on the elderly. Several
legislative proposals introduced in the 106th Congress, which may be reintroduced in
the 107th Congress, seek to create a prescription drug benefit for the Medicare
population that is managed by private entities, including pharmacy benefit managers
(PBMs).
All of the major bills introduced in the 106th Congress that would provide a
prescription drug benefit for seniors would use private entities (including PBMs) to
manage the benefit. Under S. 2342 (the President’s bill), S. 2541 (the “MEND” bill),
and S. 2758 (the “MOD” bill), the federal government would provide prescription
drug coverage to Medicare beneficiaries, but the benefit would be managed by private
entities, such as PBMs. H.R. 4680 and S. 2807 (the “Breaux-Frist” bill) would allow
private entities contracted by the federal government (likely insurers, or other risk-
bearing companies) to provide coverage; these private entities could use PBMs to
manage the benefit.
A PBM manages a prescription drug benefit on behalf of the benefit sponsor,
which may be a health plan, a health maintenance organization, or an employer. To
control costs, PBMs help determine which drugs are used and negotiate prices for
those drugs. PBMs control costs by employing mechanisms such as formularies, prior
authorization, tiered co-payments, therapeutic substitution, generic substitution, mail
order pharmacy services, disease state management, and drug utilization review.
Additionally, PBMs negotiate rebates with manufacturers and discounts with retail
pharmacies.
This report examines various options that are available to policymakers as they
consider whether to make use of PBMs to deliver a prescription drug benefit to
seniors under Medicare. With respect to a PBM benefit, the central (though not the
only) issue is implementation of cost-control mechanisms. Various techniques are
used in the private sector to control costs. As with private sector providers of
benefits, policymakers face an array of options that will determine the extent to which
the prescription drug benefit is restrictive. This report describes the operation of the
PBM industry, its techniques for serving its benefit sponsors and clients, and various
issues that are raised by the prospect of employing PBMs under Medicare. This
report will be updated as necessary.

Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
PBM Industry Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
How PBMs Operate: Cost-Saving Mechanisms . . . . . . . . . . . . . . . . . . . . . . . . . 4
Formulary Development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Manufacturer Rebates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Therapeutic Substitution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Tiered Co-payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Prior Authorization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Retail Pharmacy Discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Generic Substitution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Mail Order and Internet Pharmacy Services . . . . . . . . . . . . . . . . . . . . . . . . 7
Disease State Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Drug Utilization Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Benefits and Limitations of Cost-Saving Mechanisms . . . . . . . . . . . . . . . . . . . . . 9
Benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Limitations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
PBMs Under a Prescription Drug Benefit for Seniors . . . . . . . . . . . . . . . . . . . . 11
Major Legislative Proposals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Differences from the Private Sector . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
PBMs Under a Senior Drug Benefit: Benefits and Limitations . . . . . . . . . 16
Policy Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

Pharmacy Benefit Managers
Introduction
The price of prescription drugs receives much attention from both the press and
policymakers. The cost of drugs can impose significant financial difficulties on those
who do not have health insurance or whose health insurance does not cover
prescription drugs. Although there are uninsured in most, if not all, segments of the
population, particular emphasis has been placed on the elderly. Most elderly receive
health insurance through the government’s Medicare program, yet Medicare does not
provide coverage for most outpatient prescription drugs. While approximately 65%
of the elderly have prescription drug coverage through some sort of non-Medicare
supplement, the remaining elderly must purchase their prescription drugs out-of-
pocket.1 Even for those who have some form of prescription drug benefit, coverage
may not be sufficient given their medical needs.2
There are numerous legislative proposals that attempt to address the prices of
prescription drugs for the elderly. One proposal would allow pharmacies to buy
prescription drugs from manufacturers at the same prices that the federal government
pays for its drugs and let the pharmacies pass the savings on to elderly consumers.
Various other proposals would create a prescription drug benefit for the elderly.3 The
proposals to create a drug benefit would rely on private entities to manage the benefit
on behalf of the federal government. The private entities allowed to administer the
benefit include, but are not limited to, pharmacy benefit managers (PBMs).4 Finally,
some proposals would allow all Americans, including the elderly, to more easily
1 Michael M. Weinstein, “For Medicare, A Rocky Road To Competition,” New York Times,
February 21, 1999.
2 A study performed for the Henry J. Kaiser Family Foundation found that supplemental
benefits offered by Medicare HMOs (including a prescription drug benefit) varied greatly in
the level of coverage, with some offering very generous coverage while others offered very
limited coverage. See “Analysis of Benefits Offered By Medicare HMOs, 1999: Complexities
and Implications,” The Henry J. Kaiser Family Foundation, August 1999. Another study by
the National Economic Council states that the only meaningful form of private prescription
drug coverage is retiree drug coverage, and only 25% of the elderly have this type of coverage.
See “Disturbing Truths and Dangerous Trends: The Facts About Medicare Beneficiaries and
Prescription Drug Coverage,” National Economic Council Domestic Policy Council, July 22,
1999.
3 For a comparison of the various Medicare drug benefit proposals, see CRS Report RL30593
“Medicare: Side-by-Side Comparison of Selected Prescription Drug Bills” by Jennifer
O’Sullivan and Heidi Yacker, Updated 20, 2000.
4 Other entities that would be allowed to participate include private health plans, retail
pharmacy chains, insurance companies, and combinations of these entities.

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obtain prescription drugs from other countries, where prices may be significantly
lower than U.S. prices.5
The use of PBMs to manage a senior prescription drug benefit could have many
advantages and limitations. One advantage would be that, because PBMs would
negotiate prices with manufacturers and pharmacies, the government would not need
to take an active role in determining payments for drugs supplied to beneficiaries.
Another advantage would be that PBMs could potentially improve the quality of
pharmaceutical care that Medicare beneficiaries receive by tracking prescriptions and
seeking to prevent adverse drug reactions. However, there could also be limitations
to using PBMs for a senior drug benefit. One concern is that drugs may be added to
formularies based more on manufacturer rebates than on safety and efficacy. There
could also be a public backlash against PBM cost-control techniques if they were to
limit access to certain drugs.
The government could restrict the use of certain cost-control techniques, which
could reduce the level of savings for the government compared to those achieved in
the private sector. These limitations could be minimized in the design of the
prescription drug benefit. Formulary guidelines could be developed, the public could
be educated about the benefits of PBM cost-control techniques, and costs could be
controlled using less controversial techniques, such as tiered co-payments, mail order
pharmacy services, and physician education.
This report discusses PBMs in the context of a prescription drug benefit for
seniors. The report begins with background information on the structure of the PBM
industry. Second, the report provides a description of some of the cost-saving
mechanisms that PBMs employ. Third, the report discusses the benefits and
limitations that are associated with PBMs’ cost-saving techniques. Fourth, the report
provides a detailed discussion of PBMs in the context of an outpatient prescription
drug benefit for the Medicare population. Lastly, the report presents policy options.
PBM Industry Structure
Numerous companies provide pharmacy benefit management services. The 2000
Drug Topics Red Book lists 72 companies in its pharmacy benefit manager directory.6
According to one source, the top 20 PBMs managed about 70% of all prescriptions
covered by private third-party payers and about 47% of all prescriptions dispensed
through retail pharmacies.7 Furthermore, experts note that in 1998, the industry was
5 For a summary of these proposals, see CRS Report RL30678, “Prescription Drug Imports:
Issues Raised by the Amendments to the FY2001 Agriculture Appropriations Bill” by Donna
U. Vogt and Blanchard Randall IV, updated September 18, 2000.
6 The Drug Topics Red Book is a reference guide for pharmacists and other professionals that
purchase and supply prescription drugs. It is a companion publication of Drug Topics, a
periodical about prescription drug issues.
7 Anna Cook, Thomas Kornfield, and Marsha Gold, “The Role of PBMs in Managing Drug
(continued...)

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dominated by three firms: Merck-Medco Managed Care, PCS Health Systems, and
Express Scripts, Inc.8 In 1998, these three PBMs handled 64.2% of all prescriptions
processed by PBMs and handled 27.1% of all prescriptions dispensed in the United
States in that year.9 The relative sizes of PBMs is continually changing, however. As
recently as October 2000, Advance Paradigm, a major PBM, completed its acquisition
of PCS Health Systems.
In the early 1990s, three PBMs were acquired by pharmaceutical manufacturers.
Concerns were raised regarding the impact of these acquisitions on the
competitiveness of the industry. Specifically, some believed that the parent
pharmaceutical manufacturers would use their influence over the subsidiary PBMs to
give their products preferential treatment on the formulary.10 To address these
concerns, the Federal Trade Commission (FTC) imposed restrictions on some of the
manufacturers acquiring PBMs. One such restriction required the PBM subsidiaries
to offer open formularies, which include a wide selection of drugs, even those that
compete with the parent company’s products. In recent years, two of the three
pharmaceutical manufacturers that owned PBM subsidiaries have divested these
operations because the subsidiaries were unable to significantly increase profitability
for their parent companies.11 Currently, Merck-Medco is the only manufacturer-
owned PBM.12
However, some PBMs have been purchased by chain retail pharmacies, or chain
pharmacies have started their own PBMs. According to the PBM directory published
in the 2000 Drug Topics Red Book, Eckerd, Kmart, CVS, Walgreen, and Wal-Mart
each operate a PBM. As with manufacturer ownership of PBMs, pharmacy
ownership of PBMs may raise concerns about conflict of interest. This concern about
conflict of interest arises from the fact that a PBM determines how much it will
reimburse pharmacies for drugs dispensed to PBM patients. A PBM subsidiary
owned by a retail pharmacy could set such low reimbursement rates that other
pharmacies would lose money or refuse to do business with the PBM. The PBM’s
parent retail pharmacy company would accept such a low reimbursement rate because
its PBM subsidiary shares in the savings achieved from a low reimbursement rate; in
7 (...continued)
Costs: Implications for a Medicare Drug Benefit,” prepared for the Henry J. Kaiser Family
Foundation, January 2000.
8 “Prescription Drug Trends – A Chartbook,” Henry J. Kaiser Family Foundation.
9 Ibid.
10 For more information on the concerns associated with mergers between PBMs and
pharmaceutical manufacturers, see “Doubts Emerge About Drug Industry Mergers,” Business
& Health, November 1994. The U.S. General Accounting Office studied the impacts of such
mergers. See “Pharmacy Benefit Managers: Early Results on Ventures with Drug
Manufacturers,” U.S. General Accounting Office, GAO/HEHS-96-45, November 1995.
11 Elyse Tanouye, “Drug Makers’ PBM Strategy Produces Uneven Results; Merck’s Purchase
of Medco Pays Off, but FDA Move Clouds Future Prospects,” Wall Street Journal, February
11, 1998.
12 “Merck-Medco Leads All PBMs in Processing Retail Rxs,” Drug Benefit Trends, 11(5),
1999.

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effect, the revenues from the PBM business would subsidize low reimbursement rates
paid to the pharmacy business. The result of a PBM setting such a low
reimbursement rate is that the PBM’s parent retail company supplies all of the
prescriptions for the PBM, to the exclusion of competing pharmacies. Allegations of
setting excessively low reimbursement rates have been leveled against Rite Aid (which
sold its PBM subsidiary in October 2000) and CVS (which owns PharmaCare
Management).13 Pharmacies that own PBMs argue that the reimbursement rates set
by their subsidiaries are sufficient for their retail pharmacies to earn a profit. They
suggest that other pharmacies cannot earn a profit on the set reimbursement rates
because those pharmacies operate inefficiently.14 In the case of CVS, independent
pharmacies have filed a class action suit against the company. CVS counters that
such claims are without merit.
How PBMs Operate: Cost-Saving Mechanisms
In the private sector, PBMs administer a prescription drug benefit on behalf of
the benefit sponsor. Benefit sponsors include health plans, health maintenance
organizations, unions, and employers. Some health plans contracted under the
Federal Employees Health Benefits Program (FEHBP) also use PBMs to administer
the prescription drug portion of the health plan. In administering the benefit
(including a benefit operated through the FEHBP), PBMs utilize several techniques
that lower the cost of the benefit for the benefit sponsor. The following is a
description of some of the cost-saving mechanisms employed by PBMs.
Formulary Development
A key element of controlling the costs of a prescription drug benefit is
determining which drugs are the most cost-effective. To accomplish this, PBMs
develop formularies. A formulary is a list of drugs that the PBM deems to provide
the highest benefit to the patient at a relatively low cost. Patients who use drugs
included in the formulary will generally save their health plans more money than if the
patients were to use non-formulary drugs.
Formularies can be implemented in one of three ways: closed, open, or managed.
Under an open formulary, all drugs prescribed for a patient are covered regardless of
whether those drugs are included in the formulary. Under a closed (restricted)
formulary, the patient’s drugs are covered only if those drugs are included in the
formulary; if a patient chooses a non-formulary drug, he or she must pay the entire
cost of the drug.15 A third type of formulary is the managed formulary (also known
13 See Robert Berner, “Medicine Chess: Pharmacies Say Rates Paid by Rite Aid Unit are
Doing Them In,” Wall Street Journal, June 30, 1999. See also Robert McCarthy, “Mass
Appeal...and Suit,” Drug Benefit Trends, April 1999.
14 See Robert Berner, cited above.
15 Closed formularies tend to provide coverage for non-formulary drugs if, for medical
reasons, a patient is not able to use a formulary drug. Of course, even if there is no medical
(continued...)

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as a partly closed formulary or an incentive-based formulary). Under a managed
formulary, financial incentives are created to encourage the patient to choose
formulary drugs over non-formulary drugs. The clients of the PBM (which include
health plans, employers, unions, and health maintenance organizations) usually
determine how a formulary will be implemented in a given drug benefit.
Generally, PBMs consult with an independent pharmacy and therapeutics (P&T)
committee to assist in developing formularies. For a given ailment, there may be
several brand-name drugs that are chemically different but can be used to treat that
particular ailment. Such drugs are said to be therapeutically equivalent or belonging
to the same therapeutic category.16 Not every drug in a given therapeutic category
may be included in a formulary. The P&T committee evaluates the safety, efficacy,
substitutability, and cost of therapeutically equivalent drugs. If the P&T committee
believes that one drug provides clear medical benefits over other therapeutically
equivalent drugs, then the drug is usually added to the formulary. However, if there
are drugs that have very similar characteristics, then, based on the net cost of each
drug, the PBM may decide which drug to adopt for the formulary.17 P&T committees
usually consist of physicians, pharmacists, and medical directors; in some cases (about
38% of P&T committees) PBM personnel are committee members.18 Because of the
potential conflict of interest that might arise, many of the largest PBMs do not allow
their employees to participate in P&T committees.
The formulary provides an overall guide to which drugs patients should use in
order to achieve the greatest savings for the health plan. In general, the drug benefit
sponsor determines how the formulary is used, and relies on the PBM to enforce the
sponsor’s provisions. The formulary is not usually a stand-alone cost-control
technique. Rather, to lower costs, formularies tend to be used in conjunction with the
following practices:
Manufacturer Rebates. PBMs tend to receive rebates from a pharmaceutical
manufacturer if the PBM is able to increase the utilization of the manufacturer’s drugs
relative to competing manufacturers’ drugs (a practice referred to as “moving market
share”).19 PBMs move market share by establishing formularies, which encourage
patients (or require them, if the formulary is closed) to use certain drugs over
competing, therapeutically equivalent drugs. The rebates effectively lower the net
15 (...continued)
reason to use a non-formulary drug, a patient can still choose a non-formulary drug and cover
the cost out-of-pocket.
16 For example, antiulcer drugs, such as Zantac, Pepcid, and Axid, belong to one therapeutic
category. Antidepressant drugs, such as Prozac, Zoloft, and Paxil, belong to another
therapeutic category.
17 Terry Troy, “Defining Your Firm’s Formulary,” Managed Healthcare, February 1999.
18 Hoechst Marion Roussel’s 1998 HMO-PPO/Medicare/Medicaid Digest, cited in “More
HMOs Are Using Drug Formularies,” Drug Benefit Trends, 11(2): 8-9, 1999.
19 For more analysis on manufacturer rebates, see CRS Report RL30373, “The Cost of
Prescription Drugs for the Uninsured Elderly and Legislative Approaches,” November 24,
1999.

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prices that the benefit sponsor must pay for the prescription drugs its members use.
These rebates vary significantly across the industry, and there is no reliable data to
suggest the size of such rebates.
Therapeutic Substitution. Within any therapeutic category of pharmaceuticals,
there may be several different prescription drugs that perform the same function. A
PBM may not include every drug in its formulary; rather, it may include only one or
two drugs from each therapeutic category. If a physician prescribes a non-formulary
drug, the PBM (or a pharmacist acting on behalf of the PBM) may contact the
physician and request that the prescription be changed to a therapeutically equivalent
drug that is included in the formulary. If the physician agrees, the patient will be
prescribed a lower-cost, formulary drug in place of a higher-cost, non-formulary drug.
If the physician refuses to change the prescription, then the lower-cost drug cannot
be dispensed to the patient; the patient may or may not have to pay for the additional
cost of using a non-formulary drug, depending on how the benefit is structured by the
benefit sponsor.
Tiered Co-payments. Beneficiaries may be charged different co-payments,
depending on whether a drug is included in the formulary. For drugs that are not
included in the formulary, beneficiaries may be charged a higher co-payment than if
the drug is included in the formulary. According to one survey released in June 1999,
the average co-payment for a brand-name, formulary drug was $12.56 (ranging from
$5 to $20) while the average co-payment was $26.53 (ranging from $10 to $50) for
non-formulary drugs.20 Tiered co-payments are also used to encourage patients to
choose generic drug over brand-name drugs, which will be discussed later in the
report.
Prior Authorization
In certain cases, a health plan will not cover certain drugs unless the member
obtains prior authorization. Prior authorization is usually required for drugs that are
high cost and/or are likely to be misused (e.g. appetite suppressants, growth
hormones). For drugs that require prior authorization, the patient must meet some
pre-determined guidelines in order for the drug to be covered. For example, a patient
may be required to try an older, less expensive drug first; if this drug proves to be
ineffective, then the health plan may cover a newer, more expensive therapeutically
equivalent drug.
Retail Pharmacy Discounts
In addition to obtaining rebates from manufacturers, PBMs also obtain discounts
from retail pharmacies. A PBM often arranges a network of retail pharmacies. In
order to have their drugs covered, patients may be required to use only pharmacies
belonging to the PBM’s network. The retail pharmacies in the network agree to
accept the PBM’s reimbursement rate. This reimbursement rate is often lower than
what retail pharmacies charge cash-paying customers not covered by a health plan.
20 “Class System: Multi-Tier Benefits Take Off; Managed Care Patients Pay More for Non-
Formulary Drugs,” Business Wire, July 30, 1999.

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Pharmacies generally accept the lower PBM price because belonging to the PBM’s
network results in a larger volume of business.21 The discounted pharmacy price
results in additional cost savings for the PBM and its clients.
Generic Substitution
For many brand-name drugs whose patents have expired, generic versions of the
drugs are available. Generic drugs have the same active ingredients as the brand-
name drugs, although the inactive ingredients may be different. On average, generic
drugs are 50% less expensive than their brand-name counterparts.22 In many cases,
a generic drug will be dispensed in place of a brand-name drug even if a brand-name
drug was prescribed by the physician. Since 1984, laws facilitating the substitution
of brand-name drugs with generic drugs have existed in all 50 states.23 Generally,
pharmacists are allowed to substitute a generic drug for a brand-name drug unless the
prescribing physician specifically designates on the prescription that only the brand-
name drug is to be used.
Although pharmacies can generally switch to generic drugs without a physician’s
permission, some consumers may still prefer brand-name products. Generally, the
benefit sponsor develops incentives to encourage patients to choose generic drugs
when available, and the PBM ensures that the incentives are implemented. Private
sector benefit sponsors often choose a tiered co-payment system to encourage the use
of generic drugs. The sponsor sets one co-payment for generic drugs, sets a higher
one for brand-name drugs included in the formulary, and sets an even higher co-
payment for brand-name drugs not included in the formulary. According to one
survey released in June 1999, the average co-payment for a generic drug is $6.19
(ranging from $5 to $10) while the average co-payment is $12.56 (ranging from $5
to $20) for brand-name drugs and $26.53 (ranging from $10 to $50) for non-
formulary drugs.24
Mail Order and Internet Pharmacy Services
Many PBMs operate mail-order (and, more recently, Internet) pharmacies.
Benefit sponsors often encourage their beneficiaries to use mail-order services,
generally by charging lower co-payments for prescription filled via mail-order and
higher co-payments for prescriptions filled at traditional retail pharmacies. Mail-order
and Internet pharmacies, because they operate at lower costs than traditional retail
21 For more analysis on pharmacy discounts, see CRS Report RL30373 (cited above).
22 “The Benefit of Generic Drugs,” National Association of Pharmaceutical Manufacturers
(a trade group for generic drug manufacturers), available at
http://www.napmnet.org/Docs/benefitcontent.html.
23 Roy Levy, “The Pharmaceutical Industry: A Discussion of Competitive and Antitrust
Issues in an Environment of Change,” Bureau of Economics Staff Report, Federal Trade
Commission, March 1999, p. 18.
24 “Class System: Multi-Tier Benefits Take Off; Managed Care Patients Pay More for Non-
Formulary Drugs,” Business Wire, July 30, 1999.

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pharmacies, tend to be less expensive for the benefit sponsor.25 Furthermore, because
the patient does not expect the prescription immediately, mail order/Internet
pharmacies have more time to employ other cost-saving mechanisms, such as seeking
physician approval for therapeutic substitution or checking for adverse drug
interactions.
Disease State Management
Disease state management (DSM) is an approach to managing prescription drug
use with the goal of lowering overall health care costs. DSM also seeks to improve
the quality of care by identifying treatments that have been shown by medical
literature to offer the best outcomes while at the same time avoiding treatments that
have been shown to be ineffective. DSM follows a pre-specified protocol that begins
with the first sign of illness. Based on the results of each diagnosis, test, or
procedure, the protocol specifies the next step that should be taken to treat the
patient.
Because DSM focuses on overall health costs, it may increase the amount that
the benefit sponsor spends on prescription drugs. However, a successful DSM
program would offset any increases in drug expenditures by lowering expenditures on
physician services, hospital procedures, and other medical costs incurred by the PBM
client. DSM generally requires an integrated, coordinated approach to medical care,
an approach often taken in a managed care setting, such as a health maintenance
organization (HMO).
Drug Utilization Review
PBMs perform drug utilization review (DUR) to ensure that drug use is
consistent with the PBMs’ cost-effectiveness guidelines. DUR evaluates both patient
use and physician prescribing behavior. Among the practices examined by DUR are
whether a patient was prescribed the proper dosage, whether the patient is refilling
prescriptions too frequently (and thus overusing medication or letting medication go
to waste), and whether physicians are prescribing more non-formulary drugs than
medically necessary. DUR also screens prescriptions for drugs that may be
inappropriate for the patient, for dangerous drug interactions, for duplicate
prescriptions, for the overuse of controlled substances, and for fraud and abuse.
Actions resulting from incidents uncovered through DUR can vary. PBMs may adjust
payments or deny claims, send educational material to the physician and pharmacist,
or send a letter discussing the patient’s condition to the physician or pharmacist. In
extreme cases, PBMs may limit a patient’s coverage, drop coverage altogether, or
remove a physician or pharmacy from its network.26
25 For example, mail-order and Internet pharmacies can operate from a few regionally located
facilities, whereas traditional retail pharmacies must operate many stores located close to
customers.
26 For more description of DUR practices, see John Kralewski, Albert Wertheimer, and
Edward Ratner, “Prescription Drug Utilization Review in the Private Sector,” Health Care
Management Review, Spring 1994.

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Benefits and Limitations of Cost-Saving Mechanisms
Under normal operating conditions, there are benefits and limitations to the way
PBMs employ their cost-saving mechanisms. Some or all of these benefits and
limitations might also be expected to occur under a government-sponsored
prescription drug plan for the elderly.
Benefits
The obvious benefit of each cost-saving technique is that it contributes to the
savings that the PBM can achieve for the drug benefit sponsor. There are several
costs associated with administering a prescription drug benefit. The benefit sponsor
pays (either fully or partially) for the prescription drugs that the beneficiaries use.
Techniques such as therapeutic substitution, manufacturer rebates, retail pharmacy
discounts, generic substitution, and mail order pharmacies attempt to lower the net
prices that benefit sponsors pay for the beneficiaries’ drugs. The cost of a drug
benefit is also affected by the quantity of prescription drugs used by beneficiaries.
Techniques such as prior authorization attempt to curb the overuse of prescription
drugs by beneficiaries, leading to greater savings. Furthermore, the benefit sponsor
incurs costs when ineffective medication is prescribed to a beneficiary; in this case the
benefit sponsor must pay for the ineffective drugs as well as subsequent treatments
until the patient is effectively treated. The PBM program of disease state
management (DSM) attempts to limit these costs by limiting the use of drugs that
have been proven ineffective. Finally, the benefit sponsor incurs costs when
beneficiaries suffer from adverse health effects caused by misuse of their prescription
drugs or errors in the prescribing process. PBMs attempt to reduce these costs by
engaging in drug utilization review.
Of course, benefit sponsors could implement the cost-saving mechanisms
themselves. But PBMs offer the benefit sponsor administrative simplicity. The PBM
administers the various cost-saving techniques, while the role of the benefit sponsor
is relatively minor. Furthermore, depending on the contract arrangement, the PBM
and the benefit sponsor may have a risk sharing arrangement. Under a risk sharing
arrangement, the PBM and the benefit sponsor set a target cost per member per
month (PMPM). Any differences between the target cost and the actual cost are
divided between the client and the PBM. If the actual cost falls below the target cost,
the PBM keeps some of the savings. If the actual cost rises above the target cost,
then the PBM must bear some of the cost overruns. Under such an arrangement, the
risk of unexpected costs is passed partly from the benefit sponsor to the PBM.
Arguably, patients also benefit from the implementation of drug utilization
review by PBMs. Drug utilization review, which reviews which drugs a patient is
utilizing, can alert health care professionals about potentially harmful drug interactions
the patient may experience or patient allergies to certain medications. Such review
helps to ensure that the patient is taking the proper medication and prevent future
health problems. A PBM is not necessarily needed to ensure that a patient is receiving
the proper medication; any physician, pharmacist, or health care practician could
consult with the patient to determine what medications the patient is taking if any
problems may arise. However, that approach is limited when patients cannot

CRS-10
remember all of their medical history or when patients change physicians and
pharmacies. Some experts believe that PBMs are well suited to drug utilization
review because they maintain centralized medical profiles of patients. Health care
professionals, including those unfamiliar with the patient’s history, can access the
patient’s profile and determine whether a given medication will have adverse effects
on the patient.
Limitations
While PBMs provide substantial benefits in the private sector, some
commentators are critical of PBM cost-saving mechanisms. These criticisms center
around the use of formularies. In particular, commentators believe that the way
formularies are developed and implemented reduces safety and quality of care for
patients.27
A drug is included in formularies based on its characteristics, which include
safety, effectiveness, price, and rebates offered by the drug’s manufacturer. Some
critics are concerned that P&T committees include drugs based more on rebates than
on efficacy.28 Furthermore, in the case where the PBM may be owned by a
pharmaceutical manufacturer, critics argue that P&T committees may give preference
to drugs manufactured by the parent company.29 However, only one PBM, Merck-
Medco, is owned by a pharmaceutical manufacturer. Merck-Medco does not allow
any employee of the PBM or the parent pharmaceutical company to participate on the
P&T committee. Other PBMs have adopted similar policies; in many cases, P&T
committees do not include representatives of the PBM. This practice is to ensure that
the primary decision on whether to include a drug is based on medical concerns rather
than financial concerns. According to one survey, the most common members of
P&T committees are physicians, pharmacists, and medical directors; only about 38%
of P&T committees have PBM personnel as members.30
There has also been criticism about the use of therapeutic substitution to
promote formulary compliance. As described above, therapeutic substitution involves
switching one prescription drug for a drug which is chemically different but achieves
the same result. Therapeutic substitution requires a physician’s approval.31 Several
physicians have voiced opposition to this cost-control mechanism. These physicians
resent the questioning of their medical decisions by a PBM representative, particularly
27 See Peter Keating, “The Right Prescription? A Hard Look at the Plan to Extend Medicare
to Cover Medications,” Money, October 1999. See also Robert Pear, “Tracking Just What
the Doctor Ordered: Medicare Changes Would Bolster Prescription Management Services,”
New York Times, July 13, 1999.
28 See Robert Pear, cited above.
29 See Cook, et. al., p. 35.
30 Hoechst Marion Roussel’s 1998 HMO-PPO/Medicare/Medicaid Digest, cited in “More
HMOs Are Using Drug Formularies,” Drug Benefit Trends, 11(2): 8-9, 1999.
31 Therapeutic substitution is different from generic substitution, which does not require a
physician’s approval because generic drugs are chemically equivalent to their brand-name
counterparts.

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since the PBM representative did not examine the patient.32 It is also argued that
patients can potentially suffer adverse reactions when their medications are switched
from what was originally prescribed.33 However, if a physician believes that serious
harm would occur from therapeutic substitution, he or she could refuse to change the
initial prescription, although this could result in a higher prescription cost for the
patient.
PBMs Under a Prescription Drug Benefit for Seniors
Various legislative proposals have been introduced in the 106th Congress that
would create a prescription drug benefit for senior citizens. All of these proposals
would rely on private entities, including PBMs, to administer the benefit on behalf of
the federal government.34 While a senior prescription drug benefit failed to be enacted
in the 106th Congress, some of these proposals may be reintroduced in similar form
during the 107th Congress. This section outlines the major legislative proposals that
would use PBMs to manage a federally administered senior prescription drug benefit,
and discusses how PBMs would operate under these proposals vis-a-vis the private
sector. This section also discusses the benefits and limitations associated with using
PBMs to manage a prescription drug benefit for the Medicare population.
Major Legislative Proposals

One proposal to create a senior prescription drug benefit is the Medicare Rx
2000 Act (H.R. 4680, Representative Thomas), which was passed by the House of
Representatives on June 28, 2000. H.R. 4680 would establish prescription drug
coverage provided either by a prescription drug plan (PDP) offered by a plan sponsor
or by a Medicare+Choice organization. Beneficiaries would choose among various
plans, and the newly created Medicare Benefits Administrator would be required to
ensure that beneficiaries have at least two plans (offered by different plan sponsors)
from which to choose. PDP providers would have to be licensed by the state to bear
risk (i.e., insurance companies) or meet certain solvency criteria established by the
Medicare Benefits Administrator.
The Clinton Administration’s bill, the Medicare Modernization Act of 2000 (S.
2342, Senator Moynihan, by request) would establish a Medicare prescription drug
benefit that is administered by private entities (referred to as “benefit managers”).
The Secretary of Health and Human Services (HHS) would have the responsibility of
contracting with the entities. The bill does not specify which organizations may
32 See Robert Pear, cited above.
33 Sheryl Gay Stolberg, “Drug Switching Saves Money, but There Is a Cost,” New York
Times, June 13, 1999.
34 This report provides only a brief description of the proposals. For more detail, see CRS
Report RL30584, “Medicare: Selected Prescription Drug Proposals” by Jennifer O’Sullivan,
updated September 14, 2000. See also CRS Report RL30593, “Medicare: Side-by-Side
Comparison of Selected Prescription Drug Bills” by Jennifer O’Sullivan and Heidi Yacker,
updated September 20, 2000.

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compete for the contract to administer the benefit, but eligible entities have been
described to include PBMs, retail drug chains, and health plans. The government
would group beneficiaries into at least fifteen geographic regions, and the government
would contract with only one private entity per region. The Medicare Expansion for
Needed Drugs (MEND) Act of 2000 (S. 2541, Senator Daschle, et al) would provide
a Medicare prescription drug benefit very similar to the Administration’s proposal.
Eligible entities under MEND include prescription drug vendors, retail pharmacies,
health care providers, or any other entity the Secretary may specify, which feasibly
could include PBMs.
The Medicare Outpatient Drug (MOD) Act of 2000 (S. 2758, Senator Graham)
is another legislative proposal that would use private entities to administer a Medicare
prescription drug benefit. Under the bill, the Secretary would designate at least ten
different geographic areas and award contracts to at least two entities in each area.
Eligible entities include PBMs, health plans, insurers, retail pharmacies, or any other
entities approved by the Secretary.
The Medicare Prescription Drug and Modernization Act of 2000 (S. 2807,
Senators Breaux and Frist) would establish a new agency, the Medicare Competition
Agency (MCA), that would operate outside of HHS. The MCA would contract with
private entities to provide a prescription drug plan to beneficiaries. Eligible entities
would need to be licensed in a state to bear financial risk, or meet solvency standards
determined by the Commissioner of the MCA. An eligible entity could include a
PBM, a retail pharmacy delivery system, an insurer, or any entity the Commissioner
deems appropriate.
The role PBMs would play in a senior prescription drug benefit differs
significantly among the different legislative proposals. Some plans would have the
federal government bear the full financial risk of costs associated with coverage. That
is, the government would be responsible for paying the costs not covered by the
beneficiary cost-sharing provisions. The President’s bill (S. 2342), the MEND bill,
(S. 2541), and, to some extent, the MOD bill (S. 2758) take this approach. The role
of the PBM, or whatever private entity is contracted by the government, is to manage
the benefit in exchange for a fee. In the private sector, this approach is equivalent to
the arrangement between a PBM and a health plan or an employer. The MOD bill
would allow the private entity to take on some financial risk that is tied to its
performance in managing the prescription drug benefit; such an arrangement is used
in many private sector contracts between PBMs and their clients.
A second approach, which is taken by the Thomas bill (H.R. 4680) and the
Breaux-Frist bill (S. 2807), is for a private entity, under contract with the government,
to assume a significant portion of the financial risk associated with coverage. That
is, the private entity would be responsible for costs not covered by beneficiary cost-
sharing, though federal subsidies would offset some of these costs. In the private
sector, such an arrangement is equivalent to the relationship between an employer and
a health plan; it is also similar to the relationship between the federal government and
health plans in the Federal Employees Health Benefits Program (FEHBP). Under this
approach, it is not clear whether PBMs would bid directly for contracts with the
government, or whether health plans and insurers would be the primary bidders.
Some experts have stated that PBMs are reluctant to assume full financial risk

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associated with prescription drug coverage.35 When they do accept financial risk, it
is usually tied to their performance in controlling costs on behalf of the benefit
sponsor. For example, if the PBM is unable to negotiate manufacturer rebates to the
degree promised to the benefit sponsor, then the PBM may have to cover the
difference. Conversely, a PBM is generally not responsible for beneficiary costs
incurred because, for example, the pool of beneficiaries is relatively unhealthy and
needs to use more medications. However, it is possible that, under this approach to
a prescription drug benefit for the Medicare population, the health plans contracted
with the government would contract with PBMs to manage the benefit. A similar
situation occurs with the FEHBP, where some of the health plans in the program use
PBMs to administer the prescription drug portion of the benefit.36
Differences from the Private Sector
In some ways, the operation of PBMs under the above proposals would differ
from how they operate in the private sector. In other ways, however, PBMs would
function similarly to the private sector.
One significant difference between the private sector operation of PBMs and the
operation of PBMs under a federally administered senior drug benefit would be
beneficiary access to negotiated prices. Many of the bills require that the contracted
entities allow beneficiaries to pay the prices which the entity negotiated with
manufacturers and pharmacies, even when the beneficiary is paying the entire bill (for
example, because the beneficiary has not met the deductible or because he or she has
exceeded the coverage limits). This is significantly different from the private sector,
where PBMs pass negotiated savings directly to the benefit sponsor. It may be
feasible for PBMs to pass on savings negotiated with pharmacies directly to
beneficiaries; pharmacy reimbursement is determined in a relatively straightforward
manner.37 At the point of sale, such discounts could be deducted from the price that
beneficiaries would otherwise pay.
However, passing on rebates negotiated with manufacturers may be more
difficult for PBMs. Unlike pharmacy discounts, rebates are determined in a relatively
complex manner. Rebates from manufacturers are paid to PBMs quarterly or
semiannually. A rebate for a given prescription drug is calculated retroactively based
on, among other factors, the volume of that drug dispensed to the PBM’s
beneficiaries. At any given point of sale for the individual beneficiary, neither the
PBM nor the manufacturer will know the size of the rebate that will ultimately be
paid. Thus, it would be complicated (if not impossible) for manufacturer rebates to
35 Testimony of Carol J. McCall, Executive Vice President for Allscripts, Inc., before U.S.
Senate Committee on Finance, March 29, 2000.
36 For more information on PBMs under the FEHBP, see “Pharmacy Benefit Managers:
FEHBP Plans Satisfied With Savings and Services, but Retail Pharmacies Have Concerns”
by the U.S. General Accounting Office, GAO/HEHS-97-47, February 1997.
37 Retail pharmacies are typically reimbursed on a per prescription basis, with the
reimbursement expressed as the list price minus a negotiated percentage, plus a fixed
dispensing fee.

CRS-14
be paid to the beneficiary at the point of sale; rather, such rebates might need to be
paid to the beneficiary months after he or she purchases the medication. Furthermore,
manufacturers and PBMs keep rebate information confidential. It has been suggested
that if such information were revealed in the transaction price, manufacturers may be
discouraged from offering steep discounts.38 To be more consistent with common
PBM practices, some experts have suggested that rebates be passed to the federal
government, then passed on to beneficiaries in the form of lower premiums.39
However, one drawback of this approach is that lower premiums would benefit all
beneficiaries equally, and those with higher drug costs would not necessarily receive
a greater share of the savings.
Other than requiring negotiated prices to be passed directly to the beneficiary,
the above proposals would allow PBMs to operate similarly to how they operate in
the private sector. All of the above legislative proposals allow for the private entities
to use formularies, although the bills set certain guidelines. The Thomas bill, the
Breaux-Frist bill, and the MOD bill require formularies to include all therapeutic
categories; The Thomas bill and the Breaux-Frist bills require the formulary to include
at least one drug for each therapeutic category, while MOD bill requires that at least
two drugs from each category are included. Furthermore, the Thomas bill requires
that the formulary be developed by a P&T committee, with at least one member a
pharmacist and at least one member a physician. The MOD bill requires that
formularies comply with standards developed by the Secretary and a newly created
Medicare Pharmacy and Therapeutics Advisory Committee. The President’s bill and
the MEND bill allow the use of formularies subject to limitations and guidelines set
in the contract with the government, but the bills prohibit the Secretary from
authorizing a particular formulary or instituting a price structure.
In the private sector, the benefit sponsor typically determines a target level of
savings it wants the PBM to achieve. However, in doing so, the benefit sponsor must
consider that achieving a high level of savings requires that the PBM implement cost-
control mechanisms that may limit beneficiary access to certain drugs, such as a closed
formulary or prior authorization. The benefit sponsor may then determine which cost-
control mechanisms the PBM will use, and how they will be implemented, to achieve
the target level of savings. The benefit sponsor may decide whether a formulary is
used, and, if so, whether the formulary should be closed, open, or managed. The
benefit sponsor may also decide the size of the formulary. For example, Merck-
Medco offers benefit sponsors a choice of three different formularies, each with a
different number of drugs included, and each capable of achieving a different level of
savings. Thus, the guidelines established in the legislative proposals described above
do not differ significantly from guidelines that might be set by a private sector PBM
client. However, in private-sector plans, such choices affect the savings that the PBM
is able to achieve. Managed care organizations, such as health maintenance
organizations, generally choose a closed formulary with a limited number of drugs
available; this type of formulary is likely to achieve a relatively high level of savings.
38 See Anna Cook, Thomas Kornfield, and Marsha Gold, “The Role of PBMs in Managing
Drug Costs: Implications for a Medicare Drug Benefit,” prepared for the Henry J. Kaiser
Family Foundation, January 2000.
39 Ibid.

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Conversely, fee-for-service health plans may choose open or managed formularies
with a large number of drugs available; this type of formulary is likely to achieve a
lower level of savings relative to a closed formulary. If the final prescription drug
benefit for seniors includes provisions that require a larger formulary, then the
government should expect that PBM will achieve lower savings than if a relatively
limited formulary were permitted.
Each of the bills has a provision that allows beneficiaries access to off-formulary
drugs when medically necessary and/or allows beneficiaries to appeal entities’ denying
access to off-formulary drugs. In the private sector, benefit sponsors that use PBMs
usually adopt such provisions as well, though the appeals process may vary by client.
The Thomas bill gives beneficiaries the right to appeal the denial of coverage of an
off-formulary drug when a physician determines that the therapeutically equivalent
formulary drug is less effective or has significant adverse effects. The Breaux-Frist
bill requires the contracted entities to have a process whereby beneficiaries can appeal
the denial of coverage for off-formulary drugs. The President’s bill and the MEND
bill guarantee beneficiaries access to off-formulary drugs when medically necessary
and gives beneficiaries the right to appeal when coverage of off-formulary drugs is
denied. The MOD bill requires entities to cover off-formulary drugs when medically
necessary.
In general, the major legislative proposals do not restrict private entities from
using the cost control mechanisms commonly used in the private sector; the proposals
list what mechanisms could be used, but do not limit the private entities to those
mechanisms. The Thomas bill requires contracted entities to have in place an effective
cost and drug utilization management program, including incentives to use generic
drugs. The President’s bill and the MEND bill allow the contracted entities to employ
various cost-control mechanisms subject to guidelines defined in the contract with the
Secretary. Thus, any limitations placed on the use of certain cost-control techniques
will depend on the finalized contract reached between the private entities and the
government. However, the two bills state that the Secretary cannot “interfere with
the competitive nature of providing a prescription drug benefit through private
entities.” The MOD bill allows private entities to use mechanisms to “provide the
benefits economically” and to “encourage eligible beneficiaries to select cost-effective
drugs or less costly means of receiving drugs.” According to the bill, mechanisms that
would achieve these goals include formularies, alternative methods of distribution,
(e.g. mail order pharmacies), generic drug substitution, therapeutic substitution, and
disease management programs. The Breaux-Frist bill allows private entities to use
cost-control mechanisms “customarily” implemented by employer-sponsored health
care plans that offer coverage for outpatient prescription drugs. According to the bill,
such “customary” mechanisms include formularies, tiered co-payments, selective
contracting with providers of outpatient prescription drugs, and mail order
pharmacies.
Additionally, the Thomas bill and the MOD bill specifically require entities to
have in place utilization review systems that would detect and prevent adverse drug
interactions and prescribing errors. As described earlier, such utilization review
programs are one of the mechanisms typically employed by PBMs in the private
sector.

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Although PBMs under the major legislative proposals would not operate
differently from PBMs in the private sector, the savings achieved by PBMs on behalf
of the federal government may be less than those achieved by PBMs on behalf of
certain private sector benefit sponsors. Private sector benefits sponsors differ
significantly from each other. Some benefit sponsors prefer to aggressively control
costs, which means that utilization and access to prescription drugs must be tightly
controlled; other benefit sponsors may prefer to allow greater access and utilization,
in return for less cost control and higher expenses. How much the government saves
by using PBMs vis-a-vis the savings achieved by private sector benefit sponsors
depends on which approach the government takes. The legislative proposals
described above provide a framework, but leave much discretion to the federal
government as to how aggressively cost-control mechanisms would be implemented.
PBMs Under a Senior Drug Benefit: Benefits and Limitations
Some experts believe that using PBMs to manage a prescription drug benefit for
the Medicare population can significantly benefit the federal government and
Medicare beneficiaries. At the same time, however, there may be challenges to using
PBM techniques, particularly formularies, to manage such a benefit.
In a recent study published by the Henry J. Kaiser Family Foundation, some
experts have noted that there are many strengths to using PBMs to manage a senior
prescription drug benefit.40 One strength noted by the authors of the Kaiser study is
the lower prices PBMs are able to negotiate with pharmacies and manufacturers.
Because PBMs are able to negotiate lower prices, the government is distanced from
direct involvement in pricing and does not need to take an active role in determining
payments for drugs supplied to beneficiaries. Another benefit noted in the Kaiser
study is the potential for PBMs to improve the quality of pharmaceutical care that
Medicare beneficiaries receive. PBMs are able to track prescriptions, regardless of
where they are dispensed (including different pharmacies and mail order). By tracking
prescriptions, pharmacists can more easily conduct utilization review to prevent
adverse drug interactions or contraindications. Furthermore, according to the Kaiser
study, the pricing of PBM services is competitive in the private sector; allowing the
government to pay a competitive reimbursement rate based on PBM services may be
easier than having it determine an appropriate capitation rate for Medicare managed
care plans.
The authors of the Kaiser study also note some potential limitations that may
arise if PBMs are used to manage a senior prescription drug benefit. One such noted
limitation is the conflict of interest that may arise because PBMs may develop
formularies that are influenced by manufacturer rebates, rather than by what drugs are
the most cost-effective. The authors of the study argue that, under a senior drug
benefit, the government may need to play a role in setting formulary guidelines (much
as benefit sponsors do in the private sector). As described above, each of the
legislative proposals establish some formulary guidelines, or allow the government to
establish formulary guidelines during the contracting process.
40 Cook, et. al., cited above.

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Another limitation cited by the Kaiser study is the possibility that, under a
prescription drug benefit for the Medicare population, PBMs would be vulnerable to
public backlash over their cost-control mechanisms. Public backlash could arise if
beneficiaries do not fully understand PBM techniques for controlling costs.
According to the authors of the Kaiser study, the federal government would have a
responsibility to help educate beneficiaries about their drug benefit and the impact of
PBM cost-control mechanisms. In a separate report, the U.S. General Accounting
Office (GAO) also stated that, under a senior prescription drug benefit managed by
PBMs, beneficiaries would need to be informed about how cost-control mechanisms
affect access to their medications and the prescribing practices of their physicians.41
Each of the major legislative proposals described above has provisions requiring the
government and/or the contracted entities to disseminate information to beneficiaries
regarding the scope of their coverage.
There are other challenges related to the use of PBMs to manage a senior
prescription drug benefit, according to the Kaiser study. It is unclear, the authors of
the study state, the extent to which Congress and government agencies would allow
PBMs to use their cost-control mechanisms. In the private sector, the benefit sponsor
plays a role in determining how aggressively costs will be controlled, including which
cost-control mechanisms are used and how the formulary is implemented. Managed
care providers, such as health maintenance organizations, often employ aggressive
cost-controls, including restricting access to certain prescription drugs in favor of
therapeutically equivalent drugs that are more cost-effective. Under a prescription
drug benefit for the Medicare population, it is argued that the government is likely to
favor a less restrictive benefit than those usually employed by managed care providers.
In the private sector, PBMs work with different types of benefit sponsors, including
those that favor a restrictive benefit and those that favor a less restrictive benefit. For
PBMs to succeed under a drug benefit for Medicare beneficiaries, it is argued that
expectations on savings will need to be realistic given the choice of cost-control
mechanisms that PBMs are allowed to employ. Furthermore, according to the Kaiser
study, PBMs will need to be allowed flexibility to manage the senior benefit
effectively. As described above, the legislative proposals do not explicitly restrict the
implementation of cost-control mechanisms, though the contracting process allows
the government some discretion regarding which mechanisms will be employed.
Because some PBMs exclude patient access to certain drugs, their formularies
tend to generate controversy. Such controversy may intensify under a prescription
drug benefit for the Medicare population. Most Medicare beneficiaries are
accustomed to a fee-for-service system which allows patients to see any health care
provider willing to accept Medicare payments. The Kaiser study suggests several
ways this controversy could be minimized. First, a managed formulary (rather than
a closed formulary) could be used; formulary compliance could be achieved using
tiered co-payments, therapeutic substitution in certain drug categories, mail-order
pharmacy services, prior authorization, and physician education.42 Second, Congress
41 See William J. Scanlon, U.S. General Accounting Office. Testimony before the U.S.
Senate Committee on Finance, March 22, 2000. GAO/T-HEHS
42 According to the Kaiser study, physician education can be quite effective because a small
(continued...)

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and the federal government could set specific guidelines that PBMs would need to
follow when developing a formulary. These guidelines could require a minimum
number of drugs to be included from each therapeutic category and recommend which
therapeutic categories are most appropriate for therapeutic substitution. The
guidelines could be established by a national P&T committee. As described above,
the legislative proposals to allow PBMs to manage a Medicare drug benefit already
contain formulary guidelines similar to those recommended by the Kaiser study, such
as a national P&T Advisory Committee (the MOD bill) and guidelines specifying that
a minimum number of drugs be included (the Thomas bill, the MOD bill, and the
Breaux-Frist bill)
GAO points to several other challenges to implementing a formulary under a
prescription drug benefit for the Medicare population.43 In the private sector, P&T
committees develop formularies privately, something which, according to GAO,
“would not be tolerable for Medicare, which must have transparent policies that are
determined openly.”44 Because formularies would be developed openly and because
of the stakes involved in a drug being preferred on a formulary for the Medicare
population, GAO states that there may be intensive efforts to offer input and
scrutinize the drug selection process. Furthermore, GAO states that, even if a
formulary is in place, it may be difficult to steer utilization or prevent access to non-
formulary drugs because of the fee-for-service environment to which most Medicare
beneficiaries are accustomed. According to GAO, if utilization cannot be directed
towards one drug and away from another, then manufacturers may not have any
incentive to offer rebates. Without the effective operation of a formulary, GAO
argues that the government may need to adopt an open formulary with
administratively determined prices (much the way the government receives rebates
from the Medicaid program).45 However, administratively set prices counteracts what
Kaiser sees as a potential strength of PBMs: relying on PBMs to negotiate prices and
releasing the government from the complex process of determining appropriate prices
and discounts.
Policy Options
There are various options for structuring a benefit for the Medicare population
using PBMs. The controversy and complications cited by the Kaiser study and GAO
center around the cost-control techniques used by PBMs. Therefore, when choosing
if and how PBMs will be used to manage a senior prescription drug benefit, the major
issue that would need to be addressed is the extent to which PBMs should be allowed
to implement cost-control mechanisms similar to those used in the private sector. The
42 (...continued)
number of physicians are generally responsible for a large share of drug expenditures.
43 See Testimony of William J. Scanlon, cited above.
44 Ibid, p. 8.
45 For more information on Medicaid rebates, see CRS Report RS20295, “Outpatient
Prescription Drugs: Acquisition and Reimbursement Policies Under Selected Federal
Programs” by Heidi G. Yacker, August 9, 1999.

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options available to Congress lie along a continuum, ranging from (1) allowing
aggressive cost-controls, to (2) allowing cost-controls, but setting guidelines to
ensure a given level of access, to (3) not allowing any cost-controls that restrict
access, to (4) not using PBMs altogether.
One option for Congress is to allow strict cost-control mechanisms to be
employed. With this approach, PBMs would manage a drug benefit for the Medicare
population similarly to how they would manage a benefit sponsored by a health
maintenance organization, or any other client interested in aggressively controlling
costs. The benefit of this approach is that the government could achieve the greatest
amount of savings that PBMs can offer. PBMs would be able to easily steer drug
utilization towards the most cost-effective drugs, and they would likely be able to
negotiate relatively large rebates from manufacturers. The drawback to this approach
is that patient access would need to be significantly limited. To achieve maximum
savings, PBMs would need to implement closed formularies. According to the Kaiser
study discussed above, such an approach may lead to public backlash against PBMs.
Another option is to enact a benefit similar to those in the legislative proposals
introduced in the 106th Congress. Under these proposals, PBMs (if they are awarded
contracts by the government, or if they are contracted by government-contracted
insurers) would be able to implement many of the cost-control mechanisms employed
in the private sector. However, guidelines would ensure beneficiaries more access to
drugs than the first approach. Such guidelines could be established by the
government, or by a national pharmacy and therapeutics (P&T) committee. The
guidelines could specify a minimum number of drugs that must be available, require
that any drug be covered when medically necessary, and establish an appeals process
when beneficiaries are denied coverage. The government or the PBM could educate
beneficiaries about what cost-control techniques are employed, and how the
techniques affect access to medications. The benefit of such an approach is that
PBMs could still manage to achieve savings for the government while providing
beneficiaries access to a significant number of drugs. This approach is similar to many
private sector fee-for-service plans that use open or managed formularies. The
drawback to this approach is that the savings achieved would not likely be the same
as those achieved using the first approach. In particular, manufacturer rebates may
not be as large because the PBM would be less able to steer utilization. Furthermore,
this approach still entails restricting coverage to certain drugs in certain
circumstances, so there still may be some degree of public backlash against the use of
PBM techniques.
A third option for the government is to not allow any cost-saving mechanisms
that would restrict the ability of beneficiaries to obtain whatever drugs they choose.
If a formulary is used under this approach, it would have to be an open formulary,
with some incentives to encourage patients to use generic drugs, when available.
PBMs would be very limited in their ability to steer utilization from one brand-name
drug to a chemically different (but therapeutically equivalent) brand-name drug.
Consequently, manufacturer rebates and pharmacy discounts would not be significant.
The role of the PBM might be limited to processing claims, performing drug
utilization review and disease state management, and providing mail order pharmacy
services. The benefit of such an approach is that patients are guaranteed access to all
prescription drugs, and the risk of public backlash against PBM cost-controls is

CRS-20
minimized. The drawback of this approach is that it is unlikely that the PBM would
be able to achieve significant savings for the government. The government may be
able to achieve some savings on its own because it would become a bulk purchaser
of prescription drugs.
A last approach is to not use PBMs altogether. Under this approach, the
drawbacks of PBM cost-control mechanisms are avoided. Prescription drugs and
pharmacy services could be provided on a fee-for-service basis, much the way
physician services are currently provided under the Medicare program. The benefit
of such an approach is that patients would be assured access to all prescription drugs,
unless the government decided to implement certain restrictions. The drawback of
this approach is that beneficiaries might not use the most cost-effective medications.
This might mean that the cost of the prescription drug benefit under this approach
could be higher than under the other approaches. The government could attempt to
control costs through mandatory rebates (similar to the Medicaid program) and
setting low reimbursement rates. However, the pharmaceutical industry is strongly
opposed to any proposal which would result in federal price controls. Low
reimbursement rates to pharmacies might trigger a similar reaction if this approach is
taken. Additionally, beneficiaries would not receive the benefits associated with
PBMs, such as drug utilization review to prevent adverse drug interactions or
contraindications, and the overall efficiency frequently associated with PBM
programs.