Regulating Vertical Relationships in Prescription Drug Markets: Evidence from Medicaid

Abstract

Pharmacy benefit managers (PBMs) are third-party administrators of prescription drug programs for health insurance plans. They play a crucial role in the healthcare system by negotiating drug prices with pharmacies. Consequently, their payment structure can significantly affect the price of prescription drugs. I study the price effects of requiring PBMs and insurers to replace their default fixed-price contracts with cost-plus contracts. Using difference-in-differences methods, I find that Medicaid pre-rebate drug prices declined by an average of 17% in states that prohibited fixed-price contracting. The estimated price effects were driven by generic drugs, with slight increases in branded drug prices. These findings are consistent with cost-plus contracts reducing the ability of PBMs to profit off of asymmetric information regarding the true cost of drugs when negotiating compensation with insurers, but also inducing some PBM moral hazard by removing their profit incentives to contain costs. I also detect larger price decreases in states that rely more heavily on insurers that are not vertically integrated with a PBM. In markets where PBMs have strong informational advantages over non-integrated insurers, cost-plus contracts may be an effective means of reducing drug spending

Keywords: pharmacy benefit managers, Medicaid, vertical contracts, bargaining, drug pricing, information asymmetry, moral hazard

JEL Classification: C70, G22, I11, I13, I18, L14, L42