What Is Increasing the Cost of Generic Drugs? (Part I: The Supply Chain)

Policy Reports | Health

No. 371
Monday, September 21, 2015
by Devon M. Herrick

Executive Summary

Compared to spending on doctors and hospitals, prescription drug therapy is a bargain. Generic drugs are especially cheap; accounting for 88 percent of prescriptions filled but only 28 percent of expenditures. Within
a year after a brand drug faces competition from generics, the average price falls 80 percent or more.

Whereas the average cost of a name-brand prescription was $268 in 2011, it was only about $33 for a generic drug. 

Intense competition usually holds generic drug prices in check. Oddly, during the past few years, many generic drugs that have been on the market for decades have suddenly become more expensive. The price of more than one-fourth of generic drugs rose 10 percent to 100 percent or more in 2014. In other cases, older generic drugs have become scarce and hard to procure. Some of the reasons for drug price increases fall within the supply chain — the path a drug follows from raw ingredients to the consumer — and are discussed below.

Manufacturers and Market Consolidation. In theory, generic drugs face unlimited competition, since any qualified drug maker can apply to the U.S. Food and Drug Administration (FDA) to produce a generic version of the drug after its patent expires. The reality, however, is often far different. Due to industry consolidation — and an FDA that is slow to approve new entrants into the field — there are many generic drugs for which there are only two or three competing manufacturers.

Informal Collusion and Price-Fixing. When only a handful of producers make a given drug, the opportunities for informal collusion increase. Although it is illegal for competing firms to coordinate pricing, no law is broken when one firm unilaterally raises its price and other firms decide to follow suit.

Drug Wholesalers. The wholesale drug industry has undergone tremendous market consolidation in the past few decades. Today, three large firms control nearly 90 percent of the distribution of wholesale drugs — resulting in less price competition. Drug wholesalers have also been accused of manipulating industry price lists to boost profit margins for themselves and pharmacies.

Pharmacies. Some drugstores also function as small-scale distributors that take advantage of scarcity by diverting drugs in short supply to the wholesale gray market. Pharmacies that would normally buy drugs from wholesalers for resale instead purchase drugs at wholesale with the intention of reselling to hospitals in desperate need of those drugs.

Group Purchasing Organizations (GPOs). Most of the drugs used in hospitals must first pass through a GPO. These firms purchase supplies on behalf of numerous hospitals, thereby obtaining lower unit prices on bulk orders. Group purchasers that focus solely on price to the exclusion of having multiple sources of a drug can make the supply chain more fragile. A shortage with associated price spikes can result when a manufacturer loses a bid and exits the market.

Aging Drugs and Niche Therapies. Many of the drugs rising sharply in price are older therapies approved decades ago. Many manufacturers have dropped them either due to low profitability or in favor of newer generics that are in higher demand. In addition, when firms stop production to upgrade equipment, shortages and higher prices often result.

Raw Materials Shortages. Though it is frequently the case that there are multiple manufacturers of a drug, there may be only one or two suppliers of the raw materials used by all producers. Estimates vary, but about 10 percent of drug shortages are thought to be related to raw material shortages. 

How Not to Deal with Rising Drug Prices. Today, most health plans include prescription drug benefits. Insurers and employers often hire Pharmacy Benefit Managers (PBMs) to administer drug plans and manage drug costs. PBMs use a variety of techniques to control costs for their clients and plan members. PBMs encourage enrollees to use costeffective alternatives. They also negotiate with pharmacies and assemble preferred pharmacy networks to manage drug costs and mitigate the problem of rising prices. When price volatility affects local pharmacies, politicians often attempt to insulate drugstores and local constituents from the pain this causes. In the process, state lawmakers often make the situation worse. The following are some harmful
regulations that policymakers should avoid. 

Banning Efficient Pharmacy Networks. Increasingly, health plans and PBMs reduce premiums by negotiating
and contracting with qualified pharmacies offering competitive prices. Some states have passed any willing
pharmacy regulations to restrict the right of health plans to contract with exclusive narrow networks.

Restricting Mail-Order Pharmacies. PBMs often use discounts and lower cost-sharing to encourage beneficiaries to use convenient, low-cost mail-order pharmacies. Many state legislatures have tried to ban the use of financial incentives to reward consumers for using low-cost mailorder pharmacies.

Restricting Maximum Allowable Cost (MAC). The wholesale cost of generic drugs can vary tremendously
across a year from one manufacturer to the next. So-called MAC price lists are a tool insurance companies use to place an upper limit on plan reimbursements for a given drug. When there is no price limit, pharmacies have little reason hold costs down since they can pass on the higher cost to drug plan members. More than a dozen states have laws restricting some aspect of MAC lists.

How to Lower America’s Drug Bills. Generic drugs are inexpensive when there is competition, but less so
when conditions on the supply-side of the generic drug market hamper competition. Market consolidation and long delays at the FDA in processing applications for generic drug manufacturers tend to raise generic drug prices for consumers.

The FDA currently has a backlog of about 4,000 applications. In 2010 the median approval time for new
generic drugs was 27 months. The FDA needs to clear the backlog and allow competition to flourish. This, in turn, will alleviate some of the price hikes caused by market consolidation in both drug manufacturing and distribution. Finally, states need to resist pleas from constituents to pass perverse regulations designed to protect local businesses (and pharmacies) at the expense of competition.

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