States Declare War on Prescription Drugs

Published April 1, 2002

State elected officials across the country, hard-pressed to keep expensive promises they made during the good economic times of the 1990s, are considering legislation that would force drug manufacturers to pay “supplemental rebates”to have their drugs included in state Medicaid programs.

Experts warn these programs are likely to increase health care costs for the privately insured and uninsured and restrict choices for doctors and their patients. In the long term, supplemental rebates impose a blanket of complex rules and regulations on doctors and the pharmaceutical industry and create opportunities for corruption. There appear to be better ways to solve the problem of high drug prices.

Medicaid Rebates

Under current federal Medicaid law, manufacturers of “innovator drugs” must pay states a rebate equal to 15.1 percent of the Average Manufacturer’s Price (AMP) or the difference between the AMP and the best price the company charges its commercial customers, whichever is greater (usually 15.1 percent is the minimum rebate).

While some states use the rebate money to fund their Medicaid program, no federal law requires them to do so. The money often goes into the general fund and can be used for virtually any purpose.

Three states—California, Florida, and New Mexico—are now telling drug manufacturers that if they want their products on the Medicaid formulary (a list of approved drugs for Medicaid recipients), they must pay a “supplemental rebate” on top of the one they already pay. Those drug companies that are unwilling or unable to hand over some extra cash will find most or all of their drugs left off of the state’s formulary.

Florida adopted the supplemental rebate program in 2001, imposing an additional 10 percent rebate requirement. The law is now being litigated in the U.S. Court of Appeals for the Eleventh Judicial Circuit. According to the Center for Policy Alternatives, a liberal advocacy group promoting model legislation it calls the “Fair Market Drug Pricing Act,” bills that would mandate supplemental rebates are pending in one or both houses of 24 state legislatures. (See “Supplemental Rebate Bills Pending,” page 9.) New Mexico Governor Gary E. Johnson (R) signed legislation on March 6, 2002.

Little Effect on Spending

While the goal of supplemental rebates is to lower a state’s cost for drugs under Medicaid, the true effect is simply to shift the cost to other health care consumers and, in some cases, to other government programs. Such cost-shifting is nothing new in health care: Some actuaries argue that those with private health insurance pay about 40 percent more for health care because those in government programs (primarily Medicare and Medicaid) pay less than the actual cost of their care.

According to a study by the General Accounting Office, the original 1990 legislation allowing Medicaid rebates resulted in drug manufacturers lowering the discounts routinely offered to other purchasing groups. Price discounts in the three years following adoption of the rebates fell from 24 percent to 14 percent for HMOs and from 28 percent to 15 percent for group purchasing organizations. Overall, weighted average best-price discounts fell from 37 percent in 1999 to just 19 percent in 1994.

More evidence of the failure of prescription drug price controls can be found in Canada, a country often touted as a model by advocates of supplemental rebates. Tough restrictions on drug pricing there forced drug companies to raise prices and limit discounts on widely used drugs. Wharton professor Patricia Danzon has estimated the average U.S. consumer would spend 3 percent more for prescription drugs if he or she lived in Canada. The lower general price level of prescription drugs in the U.S. is overlooked by advocates of supplemental rebates who focus on the high prices of only a few new and relatively exotic drugs.

Requiring additional rebates from drug companies may lower prices for the government, at least temporarily, but those savings would be purchased at the expense of those outside Medicaid programs, including the uninsured and those who have private health insurance. Rising private insurance premiums, in turn, would increase the number of people who cannot afford to buy insurance.

Nationwide, health insurance premiums are expected to rise about 13 percent this year, even without the effects of supplemental rebates. (See “Health Care Spending Rockets Upward,” Health Care News, March 2002.) Those in the small group and individual health insurance markets are seeing rate increases as high as 40 and 60 percent. Additional cost-shifting through supplemental rebates will exacerbate the problem of rising premiums, and therefore increase the number of uninsured.

Ironically, those priced out of the market for private health insurance because of cost-shifting may find themselves turning to the state for coverage. Like other types of regulation on insurers and health care providers, supplemental rebates are likely to cause greater dependence on government programs and an upward spiral in public health care spending.

A Threat to Health

Limiting access to drugs through restrictive drug formularies limits what doctors can do to protect the life and health of their patients. Guaranteeing that there is a pain medication on the formulary is not the same as ensuring access to the most effective or safest drugs that could relieve a particular patient’s pain.

Proponents of supplemental rebates claim doctors can prescribe close substitutes or get special permission (known as “prior authorization”) to provide drugs not on the state’s formulary. The argument indicates naivete about pharmacotherapeutics (how drugs interact within the body) and doctors’ willingness to take on more bureaucratic paperwork. There are at least three circumstances where restrictive formularies can threaten human health.

Off-Label Prescriptions. Doctors frequently prescribe a drug for a medical condition other than the one for which it was approved by the U.S. Food and Drug Administration (FDA), a practice known as an “off-label” prescription. For some diseases, such as cancer, 60 percent of a patient’s prescriptions may be off-label.

Some years ago several members of the American Pain Society wrote the FDA about the importance of using off-label prescriptions for pain management. The doctors said they frequently used antidepressants for insomnia and pain, corticosteroids for cancer pain, antiarrythmics for neuropathic pain, and beta-blockers for migraine prophylaxis. The flexibility required for these sorts of prescriptions is seriously impeded by restrictive formularies.

Mental Illness. Most drugs are effective for most people with a medical condition for which that drug was approved. Unfortunately, the same cannot be said for diseases of the mind. Drugs for such diseases as schizophrenia and manic depressive disorder are often effective only for 50 percent of the patients, which means doctors must try other drugs until they find one that works. Limiting drug choices means some mentally ill patients simply won’t have the drug they need.

Impact on Minorities. Different ethnic groups may respond differently to different drugs. For example, African-Americans with high blood pressure tend to respond to diuretics much better than whites, and Asians respond to anti-psychotic drugs at a dosage one-tenth that required for whites. For patients with access to virtually all drugs, doctors can switch from an ineffective one to something that works. But formularies limit the number of drugs available, and requiring an additional rebate will exclude even more of them.

Since minority representation in Medicaid is disproportionately high, they are the ones who will bear the brunt of the formulary restrictions.

Ethical Problems

Advocates of supplemental rebates claim the moral high ground in the debate, saying the current drug company practice of charging different consumers different prices based on their willingness to pay is a form of unjust discrimination. But according to Linda Gorman, a health policy expert at the Golden, Colorado-based Independence Institute, “the opposite is true.” According to Gorman, price discrimination “is an efficient way to cover high fixed costs, including research and development. Discriminatory pricing also makes everyone better off by maximizing the amount of the product that is produced.”

Gorman and other experts contend discriminatory pricing is a common practice in other industries and is efficient so long as consumers are free to choose among competing firms. Advocates of supplemental rebates have demonized drug manufacturers in an attempt to make a “fairness” case for price controls, but this is just new rhetoric for a very old policy recommendation. Price controls, a key part of the failed Clinton health care reform plan of a decade ago, were rejected when it became clear they would cause massive inefficiency and lead to the denial of care to millions of patients. The latest rhetoric can’t change the underlying economic principles.

Since the people who rely on Medicaid have low incomes, the decision to remove a drug from the Medicaid formulary is essentially a decision to deny access to that drug by the poor. When Florida adopted supplemental rebates in 2001, more than 1,000 of the 1,827 brand-name drugs approved by Medicaid were not on the formulary. It is difficult to imagine a more anti-poor drug policy.

Supplemental Medicaid rebates worsen the growing trend toward a two-tier health care system in the U.S.—one system for the privately insured, and another for those who participate in government programs. Supplemental rebates would be one more in a steady stream of cost-cutting efforts that has included other price controls, restrictions, exclusions, and reporting requirements that compromise the quality of care received by the poor and elderly. Growing numbers of doctors and other health care providers simply refuse to treat Medicaid and Medicare patients due to the price controls and burgeoning paperwork requirements.

Supplemental rebates also open the door for political corruption by requiring drug companies to negotiate with government bureaucracies. Pro-rebate advocates such as the Center for Policy Alternatives claim their proposal “is based on a market approach to pharmaceutical prices” and that negotiations are “voluntary.” But negotiation is hardly voluntary when the state is demanding not only preferential terms in exchange for participation in a government program, but cash payments as well. Such arrangements more closely resemble extortion than public-private partnerships, and they are quite rightly illegal.

Supplemental rebates corrupt the political system in a second way, by allowing politicians to play a kind of shell game that may win votes but is destroying the nation’s private competitive health care industry. Politicians promise more and more “free” health care to a growing portion of the population. To pay for it without raising general taxes, which would be unpopular, politicians impose hidden taxes and shift costs through regulation onto providers and privately insured consumers.

The dishonesty of supplemental rebates becomes obvious when the confusing and uncertain label “rebate” is replaced with the much more familiar and accurate label, “tax.” Supplemental rebates are taxes on prescription drugs included in a state’s Medicaid program. Like all taxes, they raise rather than lower the true cost of the drugs, making them less available to those who need them.

Alternatives to Rebates

The supplemental rebate proposal is a symptom of a dysfunctional health care system that is gradually imploding from government interference and mismanagement. As Rep. Charlie Norwood (R-Georgia) told a meeting of the Georgia Society of Clinical Oncology last October, “every provider, every patient, every hospital in the country is reeling from the same disease: health care rationing, stemming from both managed care and Medicare/Medicaid.”

The solution is not further rationing through supplemental rebates, but to systematically reduce government involvement in health care while empowering patients and providers. Across the country, experiments and examples of this alternative reform agenda can be found:

  • Medical Savings Accounts allow patients to immediately pay for prescription drugs and health services, as well as restoring incentives for wellness and price competition in the health care market.
  • High-risk pools, such as those that operate in 31 states, offer subsidized private insurance coverage for people with very high health care costs.
  • Private patient assistance programs operated by such entities as Mature Rx, AARP, Reader’s Digest, and Pfizer, provide significant savings to low-income consumers free of charge, and for very modest annual fees for others. (See “Stop Demonizing the Good Guys,” Health Care News, November 2001.)
  • Faster approval of new drugs by the FDA would reduce the cost of new drugs by hundreds of millions or even billions of dollars each year.
  • Medicaid reform along the lines of the food stamp program—where participants get a fixed amount of money and are allowed to make their own choices and benefit from being prudent shoppers—would provide the vast majority of low-income patients with an incentive to get value for their money.
  • State insurance regulation could be reformed to allow employers to buy personal and portable insurance for their employees, to help avoid the current situation where people become temporarily uninsured when their employment ends.

Joseph Bast is president of The Heartland Institute, publisher of Health Care News. Merrill Matthews is a visiting scholar with the Institute for Policy Innovation and assistant editor of Health Care News.

For more information …

See Patricia M. Danzon, “Making Sense of Drug Prices,” from Vol. 23, No. 1 of Regulation magazine. The eight-page report is available through PolicyBot, The Heartland Institute’s free online research service. Point your Web browser to, click on the PolicyBot icon, and search for document #3264118.

Another paper by Danzon, “Can Pharmaceutical Price Regulation and Innovation Co-exist?” is also available through PolicyBot. Search for document #3264114.

“Coloradans Can’t Afford the ‘Prescription Drug Fair Pricing Act,'” a paper by Linda Gorman for the Independence Institute, is available through PolicyBot as document #3264125.