Prescription drug spending in the United States has soared in the past decade, fueled by rising prices. Nearly one in four Americans say affording their prescription drugs is difficult, while three in 10 say they haven’t taken their medicines as prescribed due to costs, according to polling from the Kaiser Family Foundation. Government budgets are strained as well, as taxpayers pay the increased costs of prescription drugs provided through Medicare, Medicaid and other government programs.
A critical mechanism for containing prescription drug prices is the formulary system. Formularies are lists of drugs covered under a particular health plan, divided into tiers that determine how much customers will pay out-of-pocket for those drugs. When health insurers place drugs on preferred tiers, patients have lower cost-sharing burdens; when health insurers place drugs on less-preferred tiers, the patient’s burden is higher. Thus, in prioritizing certain drugs over others, the tiering system — in theory — drives consumers to choose drugs that are both high-quality and cost-effective.
But anecdotal evidence has emerged that something is seriously amiss with the formulary system. Media reports and scattered lawsuits have hinted that some health plans are punishing patients for purchasing generics, rather than brand-name drugs, or completely excluding generics from reimbursement. My research has uncovered widespread abuse of the formulary system that is costing patients and taxpayers billions of dollars. Revisiting the historic roots and development of the formulary system may point the way forward to addressing this under-noticed but costly problem.
Formularies in this country can be traced to the days of the American Revolution. After George Washington’s grim retreat down the Delaware River in the winter of 1778, the wounded were treated in a chapel in Lititz, Pa. Facing shortages and disarray, an enterprising doctor wrote the “Lititz Pharmacopoeia” to standardize medical practices for field hospitals of the Continental Army. Colonial medicine blurred the line between pharmacist and physician, and the publication provided directions for preparing medications with available ingredients. Other formularies followed, helping hospitals separate legitimate cures from snake oil and standardizing the composition of medicines.
Throughout the 19th century, national formularies offered a combination of information about history, usage, dosage and preparation of medicines — sometimes in response to changing societal mores. For example, the Civil War-era obsession with elixirs, which are sweetened potions containing alcohol and water, prompted the development of what became known as “the National Formulary.” These references gradually took on legal force as the states used them as a guide for proper composition and purity. With the passage of the federal Food and Drug acts of the early 20th century, formularies gained national legal status and focused increasingly on drug effectiveness. Thus, for the first 150 years, formularies served primarily clinical functions and worked reasonably well, despite their varying content.
The vast scale of the World War II penicillin effort ushered in a new approach to drug development and manufacturing, and the industry blossomed. As more medications became available to treat diseases, hospital formularies became indispensable to manage inventory and supply. Indeed, using formularies for inventory management became a requirement in 1965 for hospitals and other health-care organizations to receive accreditation.
Formularies evolved into the realm of cost containment in the 1970s, as escalating costs drove the health insurance industry away from fee-for-service and toward “managed care” — in which patients paid set fees for health-care treatments and networks of doctors agreed to a fixed amount of compensation for particular services. To contain drug costs, health plans developed formularies for covering the drugs patients purchased at retail pharmacies. They set the lowest cost drugs, mostly generics, in the “most preferred” tier; higher cost drugs, mostly name brands, in the next tier; and expensive specialty drugs in the least-preferred tier, with some drugs left off entirely. The amount a patient would pay depended on the tier level, with the goal of channeling doctor and patient choices toward the least pricey, best option for a drug.
In the contemporary era, formularies are supposed to play multiple roles. They no longer serve as a guide for the composition and purity of medicines — that role shifted to the Food and Drug Administration — but they do carry the burden of ensuring a drug has sufficient medical justification for coverage, managing supply and most important, driving patients into more cost-effective medicines.
Over time, however, formularies have begun shifting health-care costs onto patients. Although generics are the most cost-effective drugs, they are increasingly disadvantaged in Medicare plans. Between 2010 and 2017, the percentage of generics on the most-preferred tier dropped from 73 percent to 28 percent. This is tough on patients given that in prescription drug plans covered through Medicare (including stand-alone Medicare drug plans and private health plans that contract with Medicare), the average out-of-pocket payment triples from the most-preferred tier to the next. Although the patient pays triple, the health plan pays roughly the same amount for generics on those two tiers. Thus, by moving generic drugs onto pricier tiers, the health plan is pocketing more money for drugs that cost them the same amount.
During the same period, the percentage of “irrationally tiered” drugs — that is branded drugs placed on the same or more-preferred tier than a generic with the same active ingredient — increased from 47 percent to 74 percent. This irrational tiering comes at an enormous cost to government budgets and individual patients. Looking only at the actual out-of-pocket costs paid by patients and the additional amounts paid by the federal low-income subsidy program, tier misplacement cumulatively cost society $13.25 billion over seven years. The problem is worsening, with annual wasted costs increasing roughly 8,000 percent from $50 million in 2010 to over $4 billion in 2017.
What appears to be happening is brand-name drug companies can use their market presence, volume-based rebates and the incentives of the rebate system to secure an advantageous position on an insurer’s formulary — or to entirely exclude competing drugs from reimbursement. In a system where rebates are shaping the formulary, generic drugs have been increasingly misplaced and disadvantaged in the arena of health-insurance reimbursement. Herein lies the problem. The increasing power of the rebate system has disrupted the functioning of the formulary system.
Some may argue that putting expensive brand-name drugs on cheaper tiers and forcing patients to pay more for generics is a good thing because it fuels volume-based rebates and the rebate system may help control premium costs. Putting aside the circularity of that argument — after all, the rebate system itself may be driving up drug prices and putting pressure on premiums in the first place — any such calculation is fraught with uncertainty. Right now, it seems to be putting dollars in the pockets of many players in the distribution chain — including drug companies, middle players and health plans. What is clear, however, is the measurable, extra cost shelled out by patients (along with the government programs that directly subsidize those costs) when cheaper drugs are placed on irrational tiers.
There is a simple, elegant solution that could help return formulary tiering to its intended path: requiring that health plans use list price as the basis for tier placement. Although perhaps counterintuitive, basing tiering on list price has the potential to realign incentives within the formulary system. Hidden rebate deals would become less appealing to drug companies if their drugs couldn’t secure a better position on the formulary in return. At the same time, drug companies with high prices would find their drugs deeply disadvantaged, making price increases less attractive in the first place and eliminating the need for rebates. In other words, basing tiering on list price would unwind a vicious cycle.
We need a functioning generics market if we hope to constrain prescription drug markets, and formulary reform is a critical step in supporting it. If generic markets are not competitive and thriving, little ground can be gained. Although there is no silver bullet, basing tiering on list price is a streamlined approach for cutting through a wide swath of perverse incentives and manipulations. After all, at the end of the day, it is the price that matters.