Cost Cutters or Con Artists?

Corporate Research E-Letter No. 42, December 2003


by Philip Mattera

As an interim result of the Medicare bill signed into law this month by President Bush, the 40 million participants in the federal retiree health program will soon be able to sign up for discount drug cards. Many of those cards will be issued by companies currently under investigation for fraud, anti-competitive practices and other violations of federal and state law. Those same companies are expected to play a major role when the full provisions of the Medicare drug benefit go into effect in 2006.

These big winners in the Medicare sweepstakes are known as pharmacy benefit managers (PBMs), a group of middlemen entities that are hired by private- and public-sector employers to oversee prescription drug benefits provided to workers. In theory, the PBMs are supposed to save money for employers by negotiating favorable prices with pharmaceutical manufacturers and encouraging the use of generics. They are meant to do for drug costs what HMOs, for better or worse, do for hospital and physician costs.

Yet a series of lawsuits and government investigations launched during the past few years has brought to light evidence suggesting that PBMs -- especially industry leaders Medco Health Solutions, AdvancePCS, Express Scripts and Caremark Rx -- are much better at lining their own pockets than they are at saving money for their clients. These shortcomings were conveniently overlooked by the Bush Administration and Congress in shaping a Medicare bill that relies heavily on the purported efficiencies of the private sector.


PBMs started out as discount mail-order services for certain drugs. They had been around for decades, but it was not until the 1980s that they became a big business. Much of the credit for this development is accorded to Martin Wygod, an entrepreneur who convinced large corporations that he could contain their drug costs by shipping pills directly to plan participants. The secret was to cut out the local pharmacy and to negotiate special deals with manufacturers. With help from the controversial investment bank Drexel Burnham, Wygod built his Medco Containment Services into the giant of the industry. It became known as “the Wal-Mart of pills.”

In 1993 Wygod agreed to sell Medco to drugmaker Merck & Co. for $6 billion. This was the first of a series of deals in which pharmaceutical manufacturers decided to get into the middleman business. In 1994 SmithKline Beecham agreed to purchase Diversified Pharmaceutical Services from United Healthcare Corp. for $2.3 billion. That same year Eli Lilly said it would buy PCS Health Systems from McKesson Corp. for $4 billion. Pfizer established ties with another PBM, though in the form of a strategic alliance rather than an outright purchase.

Being married to a PBM was a boon for Merck (until the business was spun off earlier this year), but it did not work well for SmithKline and Lilly. In 1999 SmithKline sold its Diversified Pharmaceutical operation to a growing PBM called Express Scripts. PCS has gone through more changes. In 1998 the drugstore chain Rite Aid agreed to buy PCS  for $1.5 billion (well below what Lilly had paid), only to sell it two years later to Advance Paradigm Inc. for just $1 billion.

These problems did not reflect the fortunes of the industry as a whole. The PBM business grew rapidly during the 1990s, and by the end of the decade it was managing the drug benefits of some 200 million Americans and was processing about three-quarters of all prescriptions covered by private third-party payers. Although there are dozens of PBMs around the country, the business is dominated by a handful of major players. Soon that handful will be even smaller, thanks to the announcement in September that Caremark Rx intends to acquire AdvancePCS for $5.6 billion. The deal is awaiting regulatory approval, but there have been reports that the federal government will not stand in the way of this further consolidation of the industry.


Despite its continuing growth, the PBM business has been dogged by charges of impropriety. The dirty little secret of the PBM companies is that they collect payments not only from their clients (employers)  but also from the pharmaceutical manufacturers with whom they are supposed to be negotiating favorable terms for those clients. The PBMs call these discounts; critics call them kickbacks paid by drugmakers to be sure that their products are included in a PBM’s formulary, or list of approved medications. Moreover, in some cases PBMs have been paid by drug companies to encourage doctors to prescribe expensive new products instead of cheaper ones that are medically equivalent. The result, critics say, is that PBMs contribute to prescription drug inflation rather than cost control.

This controversy has evolved into a spate of lawsuits and government investigations involving leading PBMs. One of the first of these was a 1997 suit brought against Medco alleging that the company violated its fiduciary responsibilities under the Employee Retirement Income Security Act. In late 2002 Medco agreed to settle this and a group of related class-action suits for $42.5 million (along with a commitment to change some of its business practices).

Yet before the case was completed, the court unsealed a batch of internal company documents. These provided a first look at the magnitude of the discounts/kickbacks received by PBMs -- amounts that the industry had taken pains to conceal. The Medco papers showed that, in a three-year period alone, the company collected some $3 billion in payments from drug manufacturers. The documents also provided evidence that Medco was paid to steer doctors toward more expensive medications.

In the wake of the Medco revelations, more lawsuits were filed against the industry. For example, in March 2003 the Prescription Access Litigation project and the American Federation of State, County and Municipal Employees sued Medco, AdvancePCS, Express Scripts and Caremark Rx in state court in California for inflating drug prices. In August 2003 two groups of retail pharmacy owners filed a federal antitrust suit against Medco and AdvancePCS. These and numerous other civil suits against major PBMs are pending.

Government prosecutors have also gotten into the act. Earlier this year there were reports that attorneys general in more than two dozen states were investigating Medco for violations of antitrust, consumer protection and other statutes. In September 2003 the Florida attorney general’s office subpoenaed Medco as part of a criminal investigation involving Medicaid.

Medco is being targeted by federal investigators as well. In June 2003 the Justice Department joined a whistleblower lawsuit that had been brought against the company by two employees who charged that Medco’s practices defrauded health plans covering federal workers. Earlier this month, DOJ expanded its charges against Medco, including an allegation that the company paid an $87 million kickback to a health plan (reportedly Oxford Health Plans) to obtain its business.


This wave of legal controversy received little attention during the Congressional debate on Medicare reform. Instead, the focus was on whether PBMs should have to disclose the payments they receive from drugmakers. In the end, the PBMs defeated the rigorous transparency proposals put forth by opponents such as the retail pharmacy industry. They also saw to it that the law does not require PBMs to pass along all the savings they negotiate with pharmaceutical manufacturers. 

It is difficult to say exactly how the PBMs accomplished this coup, but their political connections no doubt played a role. One of those connections went as high as the White House. As the website of the Center for American Progress reported on December 11, David Halbert, chief executive of AdvancePCS, is a close friend of President Bush. In fact, Bush made a $1 million profit in 1998 on his investment in Halbert’s company. This may explain why Bush has been such an avid proponent of drug discount cards despite the expectation by many observers that they will provide minimal savings to seniors.

The PBMs may be celebrating their victory in the Medicare bill, but this does not change their legal situation. Pharmacy benefit managers are riding high in the executive branch and Congress, but there will probably be more dark days ahead for them in the courts.