oversight

Drug Prices: Effects of Opening Federal Supply Schedule for Pharmaceuticals Are Uncertain

Published by the Government Accountability Office on 1997-06-11.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                 United States General Accounting Office

GAO              Report to Congressional Committees
                 and the Administrator of General
                 Services


June 1997
                 DRUG PRICES
                 Effects of Opening
                 Federal Supply
                 Schedule for
                 Pharmaceuticals Are
                 Uncertain




GAO/HEHS-97-60
      United States
GAO   General Accounting Office
      Washington, D.C. 20548

      Health, Education, and
      Human Services Division

      B-276585

      June 11, 1997

      The Honorable Fred Thompson, Chairman
      The Honorable John Glenn
      Ranking Minority Member
      Committee on Governmental Affairs
      United States Senate

      The Honorable Strom Thurmond, Chairman
      The Honorable Carl Levin
      Ranking Minority Member
      Committee on Armed Services
      United States Senate

      The Honorable Dan Burton, Chairman
      The Honorable Henry A. Waxman
      Ranking Minority Member
      Committee on Government Reform and Oversight
      House of Representatives

      The Honorable Floyd Spence, Chairman
      The Honorable Ronald V. Dellums
      Ranking Minority Member
      Committee on National Security
      House of Representatives

      The Honorable David J. Barram
      Administrator
      General Services Administration

      The federal government purchased almost $1.3 billion worth of
      pharmaceuticals during fiscal year 1996 from a catalog of prices referred
      to as a federal supply schedule. Schedule prices, which are often
      considerably lower than retail prices, are currently available primarily to
      federal purchasers. In 1994, the Congress sought to extend these lower
      prices to other government purchasers by authorizing the General Services
      Administration (GSA) to establish a cooperative purchasing program that
      would allow state, local, and Indian tribal governments and the
      Commonwealth of Puerto Rico to purchase pharmaceuticals and other
      goods and services from federal supply schedules.1 In administering the

      1
       See the Federal Acquisition Streamlining Act of 1994, P.L. 103-355, sec. 1555. The Senate-passed
      version of a pending appropriation bill would repeal sec. 1555. The House version does not contain the
      repeal. As of June 2, 1997, the bill was in conference.



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program, GSA indicated that it did not plan to open any schedule to
nonfederal entities that could result in increased prices for products on
the schedule.2

The Department of Veterans Affairs (VA), to which GSA has delegated
administration of the pharmaceutical schedule, raised concerns that drug
manufacturers would seek to increase schedule drug prices if a larger
group of purchasers was given access to those prices. As a result, GSA
proposed that the pharmaceutical schedule be excluded from the
cooperative purchasing program because opening it would have the
unintended effect of increasing federal agencies’ drug costs.

Because of concerns about the potential effects of opening more than 140
federal supply schedules to state and local governments, the Congress
directed GSA to delay opening the schedules, including the pharmaceutical
schedule, pending completion of our assessment of the possible impact.3
This report focuses on the factors that can affect negotiations for schedule
drug prices and the potential effects of opening the pharmaceutical
schedule4 on schedule prices available to federal, state, and local
government purchasers.5

To address the report’s objectives, we interviewed representatives of
federal agencies that purchase the most products from the pharmaceutical
schedule: VA, the Department of Defense (DOD), and the largest Public
Health Service drug purchaser, the Indian Health Service. In addition, we
interviewed representatives of the Public Hospital Pharmacy Coalition,6
the Health Industry Group Purchasing Association (HIGPA),7 and two group



2
 See Cooperative Purchasing: Effects Are Likely to Vary Among Governments and Businesses
(GAO/GGD-97-33, Feb. 10, 1997), pp. 19-21.
3
 See the National Defense Authorization Act for Fiscal Year 1996, P.L. 104-106, sec. 4309 (1996), and
accompanying conference report, H.R. Conf. Rep. No. 104-450, at 970 (1996). The act requires that we
submit our report to the Administrator of General Services and to the Congress.
4
 The implications of opening other schedules are discussed in GAO/GGD-97-33, Feb. 10, 1997.
5
 For the purposes of this report, Indian tribal governments were considered with federal purchasers
because the pharmaceutical and other federal supply schedules are available to them under separate
authority (see GAO/GGD-97-33, Feb. 10, 1997). Potential effects on the Commonwealth of Puerto Rico
were considered with state and local governments.
6
 The Coalition represents 70 public hospitals that are owned or controlled by state and local
governments and serve a disproportionate share of Medicaid and indigent patients.
7
 HIGPA is a national trade association that represents 84 organizations and vendors that purchase
pharmaceuticals and other medical products.



Page 2                                                       GAO/HEHS-97-60 Pharmaceutical FSS
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                   purchasing organizations that represent public hospitals and clinics.8 We
                   also interviewed representatives of the National Association of Chain Drug
                   Stores, the Pharmaceutical Research and Manufacturers of America
                   (PhRMA), and several drug manufacturers.9 We analyzed pharmaceutical
                   schedule prices obtained from VA and reviewed assessments made by VA,
                   HIGPA, and the Public Hospital Pharmacy Coalition of how opening the
                   schedule could affect schedule and other drug prices. Although we
                   reviewed economic and other assumptions used in these assessments, we
                   did not validate the supporting data, such as drug prices and expenditures.
                   We also reviewed public comments on GSA’s proposed regulations and
                   discussed the potential effects of opening the federal supply schedule with
                   officials of the Congressional Budget Office (CBO).

                   We did our work between October 1996 and April 1997 in accordance with
                   generally accepted government auditing standards.


                   The effects of opening the federal supply schedule for pharmaceuticals on
Results in Brief   schedule prices ultimately depend on the outcome of negotiations
                   between VA and drug manufacturers. Because of the uncertainties related
                   to these negotiations, it is not possible to predict how schedule drug prices
                   would change or what the ultimate impact on federal, state, and local
                   purchasers would be.

                   Although many factors would influence the negotiations between VA and
                   drug manufacturers, two primary ones are VA’s negotiating ability and
                   manufacturers’ pricing strategies. Both of these factors would be
                   influenced by the size of the market represented by combined federal,
                   state, and local purchasers that would have access to schedule prices.
                   Moreover, the size of this market could affect the size of any resulting
                   price changes. The larger the market, the greater the economic incentive
                   would be for a manufacturer to raise schedule prices to limit the impact of
                   giving low prices to more purchasers.

                   At present, federal purchases from the schedule represent about
                   1.5 percent of the total dollar value of domestic pharmaceutical sales.
                   Estimates of the size of a combined federal, state, and local market,
                   however, vary widely because of uncertainty about which state and local
                   entities would be eligible for schedule prices. If eligibility is not narrowed,

                   8
                    Some group purchasing organizations represent hundreds of hospitals and have been able to negotiate
                   significant price discounts for them.
                   9
                    The manufacturers we contacted were Eli Lilly and Company; Johnson & Johnson; Merck & Co., Inc.;
                   Pfizer Inc.; and SmithKline Beecham Corporation.


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             VA, PhRMA,  drug manufacturers, and the Public Hospital Pharmacy Coalition
             agree that the size of the combined market could be significantly larger
             than the current federal market. Although the Coalition estimates that
             limiting eligibility as it suggests could keep state and local purchases from
             the schedule at between 0.5 and 4.4 percent of domestic pharmaceutical
             sales, this would result in a combined market about 33 to 300 percent
             larger than the federal market.

             Federal efforts to lower Medicaid drug prices suggest how opening the
             pharmaceutical schedule could put upward pressure on schedule prices.
             In 1990, the Congress required drug manufacturers to give state Medicaid
             programs rebates for outpatient drugs based on the lowest prices they
             charged other purchasers. Because of the size of the Medicaid market,
             however, many drug manufacturers sought to minimize the impact of the
             rebates on their business by raising outpatient drug prices to some private
             sector purchasers.

             If the pharmaceutical schedule were opened to state and local
             governments and drug manufacturers succeeded in raising their schedule
             prices in response, the impact on different government purchasers would
             vary. VA, DOD, the Public Health Service, and the Coast Guard would be
             somewhat protected from price increases because the Veterans Health
             Care Act of 1992 sets maximum prices for these agencies for over
             one-quarter of the drugs on the schedule. Other federal purchasers would
             not have that protection. State and local government purchasers,
             meanwhile, would benefit to the extent that schedule prices were lower
             than the prices they or their representatives could negotiate with drug
             manufacturers.


             The federal supply schedule (FSS) for pharmaceuticals is a price catalog
Background   currently containing almost 23,000 pharmaceutical products10 available to
             federal agencies and institutions and several other purchasers, such as the
             District of Columbia, U.S. territorial governments, and many Indian tribal
             governments. VA, to which GSA has given responsibility for administering
             the pharmaceutical schedule, negotiates prices with drug manufacturers. It
             is also the largest purchaser from the schedule; in fiscal year 1996 it made
             purchases of about $922 million—or about 71 percent of the government’s
             purchases from the pharmaceutical FSS.



             10
              The FSS may list the same drug in different dosage amounts and package sizes. Each listing is
             considered an individual item or product in counting the total number of products on the FSS.



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While the pharmaceutical FSS, like other supply schedules, is meant to
provide eligible entities an efficient and economical option for purchasing,
other options exist. For example, although VA depends on the FSS for most
of its drug purchases, it has awarded several national contracts on a
competitive basis for specific drugs it considered to be therapeutically
interchangeable. VA spent about $1.2 billion on pharmaceuticals in fiscal
year 1996 through both FSS and national contract purchases.

Under the Veterans Health Care Act, drug manufacturers must make their
brand-name drugs available through the FSS in order to receive
reimbursements for drugs covered by Medicaid.11 The act also requires
drug manufacturers to sell drugs covered by the act to four agencies—VA,
DOD, the Public Health Service, and the Coast Guard—at no more than
76 percent of the nonfederal average manufacturer’s price,12 a level
referred to as the federal ceiling price. The FSS price may be higher or
lower than the ceiling. If it is higher, the protected purchasers pay no more
than the ceiling price, while purchasers not protected by the act—such as
the Bureau of Prisons and institutions in the District of Columbia like
Howard University and St. Elizabeths Hospital—pay the full FSS price.

Although state and local government entities have not had access to FSS
drug prices, they have been able to purchase drugs at significantly
discounted prices. For example, the Veterans Health Care Act gave certain
hospitals that serve a disproportionate share of Medicaid recipients and
certain categories of federally funded clinics access to discounted prices
on outpatient drugs similar to those given state Medicaid programs.13 In
addition, public hospitals have obtained significant discounts off retail and
wholesale prices for both outpatient and inpatient drugs by using large
group purchasing organizations to negotiate with drug manufacturers.

GSA published its proposed plan for implementing the Federal Acquisition
Streamlining Act as it related to opening the federal supply schedules to

11
  See P.L. 102-585, sec. 603. The act covers innovator multiple-source drugs, single-source drugs,
insulin, and biological products such as vaccines and antitoxins. Innovator multiple-source drugs are
ones that were approved by the Food and Drug Administration as original new drugs but that now
have competing drugs, including generic versions, that have the same combination of active
ingredients. Conversely, single-source drugs are original drugs that have a unique combination of
active ingredients unavailable in other drugs. The act does not cover noninnovator multiple-source or
generic drugs.
12
 The nonfederal average manufacturer price is the weighted average price of each single form and
dosage unit of a drug that is paid by wholesalers in the United States to a manufacturer, taking into
account any cash discounts or similar price reductions. Prices paid by the federal government are
excluded from this calculation.
13
  See P.L. 102-585, sec. 602.



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                         state and local governments in the Federal Register on April 7, 1995. The
                         plan proposed excluding from cooperative purchasing the schedule for
                         drugs and pharmaceutical products14 and one medical equipment and
                         supplies schedule.15 In the plan, GSA specified that unique statutory
                         requirements in the Veterans Health Care Act affect the pricing and
                         availability of products on both schedules and that when combined with
                         the cooperative purchasing provisions, would have the unintended effect
                         of increasing costs to federal users of the schedules. The plan also
                         proposed that participation in the cooperative purchasing program be
                         optional for both sellers and purchasers of goods and services. In
                         comments GSA received on the plan, PhRMA, VA, and about 30 drug
                         manufacturers supported GSA’s proposal to keep the pharmaceutical FSS
                         closed to state and local governments, while the Public Hospital Pharmacy
                         Coalition and over 60 public hospitals supported opening the schedule.


                         Price negotiations between VA and drug manufacturers would ultimately
Impact of Opening the    determine the extent to which opening the pharmaceutical FSS affects the
FSS Depends Largely      schedule drug prices available to federal, state, and local governments.
on Price Negotiations    VA’s negotiating ability and drug manufacturers’ pricing strategies are two
                         primary factors that would influence the outcome of those negotiations.
                         Moreover, the size of the market that could gain access to FSS prices could
                         affect the size of any resulting price changes. That is, the larger the
                         market, the greater the incentive would be for drug manufacturers to raise
                         FSS prices to limit the impact of giving low prices to more purchasers.



FSS Negotiations and     In its role as administrator of the pharmaceutical FSS, VA negotiates prices
Manufacturer Pricing     for the nearly 23,000 drug products listed on the schedule. Under GSA
Strategies Are Driving   procurement regulations, VA contract officers are required to seek an FSS
                         price that represents the same discount off a drug’s list price that the
Forces                   manufacturer offers its most-favored nonfederal customer under
                         comparable terms and conditions.16 To help VA determine the
                         “most-favored customer” discount, manufacturers provide VA information
                         on price discounts and rebates offered different domestic customers and
                         on the terms and conditions involved, such as length of contract periods
                         and ordering and delivery practices.



                         14
                           Federal Supply Classification Group 65, part I, sec. B.
                         15
                          Federal Supply Classification Group 65, part VII. The implications of opening this schedule (in vitro
                         diagnostic substances, reagents, test kits, and sets) are covered in GAO/GGD-97-33, Feb. 10, 1997.
                         16
                           See 48 C.F.R. sec. 538.270.


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GSA regulations recognize, however, that the terms and conditions of
commercial sales vary and that there may be legitimate reasons why VA
does not always obtain the most-favored customer discount. Hence, the
regulations also allow VA’s contract officers to accept a less favorable price
if an officer determines that (1) the price offered to the government is fair
and reasonable, even though a comparable discount was not negotiated,
and (2) awarding the contract is otherwise in the best interest of the
government.

Opening the pharmaceutical schedule to state and local purchasers could
change the dynamics of negotiating FSS prices for both VA and drug
manufacturers. Up to now, VA has been able to obtain significant discounts
from drug manufacturers by seeking the most-favored customer price.
Many FSS prices are more than 50 percent below nonfederal average
manufacturer prices.17

Representatives of several drug manufacturers explained that their
companies have been willing to give federal purchasers such low prices
because they consider the FSS to be a special, limited category of pricing
that affects no more than about 2 to 3 percent of total dollars in domestic
pharmaceutical sales. Two representatives also told us that their
companies gave VA favorable FSS discounts to help ensure that their drugs
were widely used in VA hospitals where many of the nation’s physicians
receive part of their training. But some drug manufacturers have indicated
an unwillingness to offer the same low prices to an expanded group of
government purchasers as well as an unwillingness to combine different
types of purchasers that the manufacturers are accustomed to treating as
separate markets.

Opening the pharmaceutical and other schedules is intended to help
government purchasers take advantage of the total volume represented by
federal, state, and local sales to negotiate lower prices with sellers. But
while volume of sales is integral to pharmaceutical price negotiations
between purchasers and drug manufacturers, it is not the only important
consideration. Drug manufacturers have historically offered different
prices for the same product to different purchasers based largely on the
purchasers’ ability to influence drug utilization (sometimes referred to as
the ability to move market share).18 A common technique used by

17
 Drugs covered by the Veterans Health Care Act that had FSS prices below federal ceiling prices as of
Sept. 30, 1996, were, on average, 52 percent below the nonfederal average manufacturer price.
18
 See CBO Papers: How the Medicaid Rebate on Prescription Drugs Affects Pricing in the
Pharmaceutical Industry (Washington, D.C.: CBO, Jan. 1996).



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large-volume purchasers to influence utilization is to establish a formulary.
A formulary is a list of drugs that a health plan prefers its physicians to
prescribe for patients. Drugs are included on a formulary not only for their
medical value but also for their favorable prices. Both inclusion of a drug
on a formulary and its cost can affect how much it is prescribed and
purchased and, therefore, can affect its market share. Because formularies
have the potential to significantly affect the sales of drugs, large
purchasers that use them have greater leverage in negotiating discounts or
rebates with manufacturers that want their drugs listed as preferred drugs.
But because the FSS is a catalog of prices, not a formulary, VA lacks that
kind of leverage. Access to FSS prices by state and local entities that use
formularies, such as public hospitals, would not change the status of the
FSS as a catalog.19 Therefore, although VA would be negotiating on behalf of
a larger market if FSS prices were made available to state and local
governments, the increased size of the market may not in and of itself
improve VA’s leverage to negotiate lower prices.

If drug manufacturers are unwilling to extend low FSS prices to state and
local purchasers, VA contract officials expect a “showdown” with
manufacturers over price increases that they have not experienced before.
The potential for such a change in the dynamics of setting FSS prices was
emphasized by several manufacturers’ representatives. For example, they
told us they consider drug sales to public hospitals a large enough market
segment to influence current pricing decisions, even without having to
give them and other state and local purchasers low FSS prices.

Because of their unwillingness to give state and local purchasers FSS
prices, drug manufacturers could respond to the opening of the schedule
in several ways. First, drug manufacturers could simply refuse to offer
their products to state and local purchasers at FSS prices, an option that is
permitted under GSA’s current proposal. Representatives of several
manufacturers told us, however, that they do not consider this option
realistic because some competing manufacturers would be likely to offer
FSS prices to state and local purchasers, a market too important to their
companies’ sales to ignore. Second, drug manufacturers could try to
increase FSS prices by raising prices to most-favored customers to change
the base on which prices are negotiated with VA. Several manufacturers
have acknowledged that depending on the size of the market represented
by all government purchasers, this could be an option. Third, drug
manufacturers could attempt to negotiate higher FSS prices without linking

19
 PhRMA contends that opening the pharmaceutical schedule would actually negate the ability of state
and local purchasers to influence drug utilization and, therefore, to move market share because they
would be considered part of an FSS market in drug price negotiations with manufacturers.



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                              them to most-favored customer prices. VA contract officials believe that
                              this strategy could result in lengthy and difficult negotiations that they
                              have not experienced before with manufacturers. Ultimately, VA officials
                              could choose not to list those drugs on the FSS for which they were unable
                              to reach agreement on price with manufacturers. VA contract officials,
                              however, believe that incentives would exist for manufacturers to reach
                              agreement with VA on price because drugs covered by the Veterans Health
                              Care Act must be included on the pharmaceutical FSS for drug
                              manufacturers to receive reimbursement for drugs covered by Medicaid.


Size of Market Eligible for   The size of the market eligible to buy drugs at FSS prices if the schedule is
FSS Prices Would Be Key       opened to state and local governments would be a key factor in
Factor                        determining what would happen to drug prices. The size of the market
                              involved would affect both VA’s ability to negotiate and manufacturers’
                              pricing strategies. The larger the market, the greater the incentive would
                              be for manufacturers to raise FSS prices to limit the impact on their
                              business of giving low prices to more purchasers.

                              Representatives of VA, PhRMA, drug manufacturers, HIGPA, and the Public
                              Hospital Pharmacy Coalition agree that unless the definition of which state
                              and local entities are to have access to the schedule is narrowed, the FSS
                              market could expand significantly from its current size of about 1.5
                              percent of domestic pharmaceutical sales.20

                              GSA’s proposed implementation plan for opening the FSS would make any
                              state and any department, agency, or political subdivision of a state,
                              including local governments eligible to participate.21 Because GSA
                              proposed that each state verify participants’ eligibility, it is possible that
                              states would interpret the definition in different ways. Both purchasers
                              and sellers, including retail pharmacies, believe that the proposed
                              definition could allow a large number of entities to qualify for FSS prices.
                              For example, PhRMA and the Coalition note that if entities that do not
                              actually purchase and take possession of pharmaceuticals themselves,
                              such as home health agencies and board and care homes are eligible, the



                              20
                                According to IMS America, a private vendor of pharmaceutical information, in 1996 the U.S.
                              pharmaceutical market totaled about $85.4 billion in sales, including sales to federal, state, and local
                              government entities. FSS drug sales of about $1.3 billion for fiscal year 1996 represent about
                              1.5 percent of U.S. pharmaceutical sales.
                              21
                                 See GSA’s Federal Register notice, Apr. 7, 1995, and the Federal Acquisition Streamlining Act of 1994,
                              P.L. 103-355, sec. 1555.



                              Page 9                                                         GAO/HEHS-97-60 Pharmaceutical FSS
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number of organizations that could purchase drugs at FSS prices could be
substantial.22

PhRMA, several drug manufacturers, and the National Association of Chain
Drug Stores expressed concern that a broad definition of eligibility could
also increase the potential for drugs purchased at FSS prices to be diverted
to individuals or groups not meant to benefit from the program.23 For
example, they believe that if eligibility is loosely defined, an organization
that does not take possession of drugs or purchase drugs for its own use
could buy drugs at FSS prices and attempt to resell them to individuals or
groups that may not be state or local entities. In addition to being
concerned about diversion, retail pharmacies are also concerned that
opening the FSS would give state and local government entities access to
drug prices that could be considerably lower than those retail pharmacies
pay. Since publishing its proposed implementation plan for opening the
FSS, GSA has considered several modifications. These include more
specifically defining which entities would be eligible to participate in
cooperative purchasing, requiring GSA—rather than states—to determine
entities’ eligibility, and prohibiting the resale of products purchased off the
schedule.

The Public Hospital Pharmacy Coalition has suggested that GSA’s definition
be narrowed to limit access to FSS prices to state and local government
entities that purchase drugs for their own use and dispense drugs in their
own facilities. The Coalition estimated that defining eligibility that way
would result in a state and local FSS market of about 4.4 percent of total
dollars in domestic pharmaceutical sales.24 Figure 1 shows the potential
composition of the state and local market for FSS sales based on the
Coalition’s proposal.




22
  Coalition estimates indicate that these types of facilities could represent over 30 percent of about
7,900 potential eligible state and local entities.
23
  PhRMA noted that the Congress acknowledged the potential for diversion of discounted products in
the Veterans Health Care Act. Sec. 602 provided safeguards to ensure that entities receiving discounted
outpatient drugs under the program would not resell those drugs to other entities.
24
 See PRIME Institute, College of Pharmacy, University of Minnesota, Section 1555 of the Federal
Acquisition Streamlining Act: Impact of Cooperative Purchasing on the Pharmaceutical Market,
prepared for the Public Hospital Pharmacy Coalition (Washington, D.C.: Jan. 15, 1997).



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Figure 1: Composition of the State and
Local Market for FSS Sales Based on
the Public Hospital Pharmacy
Coalition’s Proposal
                                                                                            5.3%
                                                                                            Psychiatric Hospitals

                                                                                            1.2%
                                                                                            Chronic and TB Hospitals

                                                                                            8.4%
                                                                                            Mental Retardation Residential
                                                                                            Facilities

                                                                                            Mental Health Facilities


                                                          •         •


                                                                        13.4% •
                                                                                            1.5%
                                                                            •               Skilled Nursing Facilities



                                                    67.0%
                                                       •




                                                                                            3.2%
                                                                                            Correctional Institutions

                                                                                            Community Hospitals




                                         Note: Percentage estimates are based almost exclusively on 1993 drug expenditures for
                                         approximately 5,760 entities.

                                         Source: The Public Hospital Pharmacy Coalition.




                                         But the market might actually be considerably smaller, according to the
                                         Coalition, for two reasons. First, some state and local purchasers are
                                         subject to procurement laws or regulations that would restrict their
                                         participation in the cooperative purchasing program. Second, eligible state




                                         Page 11                                                  GAO/HEHS-97-60 Pharmaceutical FSS
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and local purchasers that choose to participate probably would not buy all
their drugs through the program because some FSS prices would be higher
than the drug prices they or their representatives could negotiate with
manufacturers. If these two assumptions are considered, the Coalition
estimated that state and local FSS purchasers would represent about
0.5 percent of the total drug market. The Coalition’s estimates mean that
the total FSS market would expand by between about 33 and 300 percent if
state and local governments are given access to FSS prices.

As for the impact of procurement laws or regulations on state and local
participation, 27 of 50 respondents25 reported in a September 1996 survey
we conducted that current state competitive-bidding and other laws would
limit their use of federal supply schedules.26 But most state and local
government purchasing officials we contacted indicated that they want the
option of purchasing items from the schedules. How many states and
localities would change purchasing laws and regulations so that they could
participate in the cooperative purchasing program is uncertain. It is also
uncertain how many and to what extent eligible state and local entities
would choose to buy drugs through the FSS rather than rely on the prices
they negotiate themselves with manufacturers.

Although the size of the combined federal, state, and local market that
could have access to FSS prices if the schedule is opened is unclear, past
federal efforts to lower drug prices for a significant market segment
caused many manufacturers to raise prices. Before the Medicaid rebate
program was enacted in 1990, state Medicaid programs, which represent
about 11 percent of the domestic pharmaceutical market,27 paid close to
retail prices for outpatient drugs. Other purchasers, such as hospitals and
health maintenance organizations, paid considerably less. Under the
program, the Congress required drug manufacturers to give state Medicaid
programs rebates for outpatient drugs based on the lowest prices they
charged other purchasers.

After the rebate program’s enactment, the prices many large private
purchasers paid for outpatient drugs increased substantially. In particular,
prices paid by health maintenance organizations rose, on average, more


25
  Respondents represented 48 states and 2 territories.
26
  See GAO/GGD-97-33, Feb. 10, 1997.
27
  According to IMS America, in 1995 total sales for the U.S. pharmaceutical market were about
$77.1 billion. According to the Health Care Financing Administration, Medicaid drug expenditures for
fiscal year 1995 totaled about $8.4 billion, including rebates.



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                         than twice as fast as the year before the program.28 Moreover, the lowest
                         outpatient drug prices in the market increased faster than the drugs’
                         average prices29 as drug manufacturers significantly reduced the price
                         discounts they offered private purchasers.30 On the basis of its analysis of
                         these price changes for outpatient drugs, the Congressional Budget Office
                         concluded that because of the size of the market represented by Medicaid,
                         “pharmaceutical manufacturers are much less willing to give large private
                         purchasers steep discounts off the wholesale price when they also have to
                         give Medicaid access to the same low price.”31


                         How FSS prices would change if the pharmaceutical FSS is opened cannot
FSS Price Changes        be predicted given the uncertainties about the outcome of negotiations
Would Affect             between VA and drug manufacturers. The factors involved in these
Government               negotiations and the subsequent outcomes could vary for different drugs.
                         For example, the factors involved in negotiating FSS prices for unique,
Purchasers Differently   single-source drugs may differ greatly from those involved in negotiating
                         FSS prices for drugs that have competing, generic versions. At a minimum,
                         federal, state, and local purchasers have options for the sources they can
                         use to purchase generics.

                         If the pharmaceutical schedule is opened, however, the factors involved in
                         negotiations between VA and drug manufacturers could produce, in
                         general, an upward pressure on FSS prices. As described earlier in this
                         report, such factors include a change in the dynamics of negotiations
                         between VA and drug manufacturers, continued limitations on VA’s leverage
                         to negotiate, and uncertainties about the size of the overall market that
                         would be represented by sales to federal, state, and local purchasers. If FSS
                         prices were to rise, the impact on federal purchasers would vary between
                         those that are protected by ceiling prices for drugs covered by the
                         Veterans Health Care Act and other federal purchasers that are not. The

                         28
                          See Medicaid: Changes in Drug Prices Paid by HMOs and Hospitals Since Enactment of Rebate
                         Provisions (GAO/HRD-93-43, Jan. 15, 1993).
                         29
                          See Medicaid: Changes in Best Price for Outpatient Drugs Purchased by HMOs and Hospitals
                         (GAO/HEHS-94-194FS, Aug. 5, 1994).
                         30
                           A study conducted for HIGPA contended that opening the pharmaceutical FSS could result in similar
                         reductions in drug price discounts to private purchasers. See Muse & Associates, The Federal
                         Acquisition Streamlining Act of 1994: The Effect of Federal Supply Schedule Expansion on
                         Expenditures for Health Care Products (Washington, D.C.: Oct. 1996).
                         31
                           See CBO Papers: How the Medicaid Rebate on Prescription Drugs Affects Pricing in the
                         Pharmaceutical Industry. CBO also noted that many FSS prices increased significantly, perhaps
                         because FSS prices were initially considered with private sector prices in calculating rebates. In 1992,
                         in the Veterans Health Care Act the Congress exempted all drug prices paid by federal entities from
                         rebate calculations.



                         Page 13                                                       GAO/HEHS-97-60 Pharmaceutical FSS
                          B-276585




                          effects of FSS price increases on state and local purchasers would depend
                          on whether FSS prices are lower than the prices they can negotiate
                          independently with drug manufacturers.


For Federal Purchasers,   If FSS prices rise after the schedule is opened, all federal purchasers could
Impact of Any FSS Price   pay higher FSS prices for drugs not covered by the Veterans Health Care
Increases Would Vary      Act. As seen in figure 2, about 73 percent of the roughly 22,800 drugs on
                          the FSS are not covered by the act.32 The noncovered drugs, however, are
                          generally generic drugs, and though they constitute most of the drugs on
                          the FSS, they represent a smaller portion of federal expenditures because
                          of the lower prices charged for generics. A VA official estimated that about
                          three-quarters of VA’s total drug expenditures are for covered drugs.33




                          32
                           As of Sept. 30, 1996, the FSS included 22,828 products—6,243 were covered drugs and 16,585 were
                          not covered.
                          33
                            Expenditure data were not readily available for products on the pharmaceutical FSS.



                          Page 14                                                     GAO/HEHS-97-60 Pharmaceutical FSS
                                          B-276585




Figure 2: FSS Price Relative to FCP for
Schedule Drugs as of September 30,                                                                FSS Price Above FCP
1996


                                                                        16.9% •


                                                                                •                 2.4%
                                                                                                  FSS Price Same as FCP
                                                                                    •


                                                 72.7%
                                                    •




                                                                                                  8.0%
                                                                                                  FSS Price Below FCP

                                                                                                  FSS Price Not Subject to FCP




                                                    Not Covered by the Veterans Health Care Act

                                                    Covered by the Veterans Health Care Act



                                          Note: Percentages are based on the number of FSS products, rather than FSS expenditures.

                                          Source: VA data.




                                          For drugs that the act covers, VA and the three other protected federal
                                          agencies would not have to pay FSS prices that are higher than the federal
                                          ceiling prices (FCP). But as figure 2 shows, they may have to pay more for
                                          the 8 percent of all FSS drugs that currently have FSS prices below the
                                          ceiling prices if manufacturers succeed in raising those prices to or above
                                          the ceilings. The increases could be substantial given that, on average, the
                                          FSS prices for these drugs are about 28 percent below the ceiling price.
                                          Hence, VA and the other protected agencies could experience price
                                          increases for almost 81 percent of all the drugs on the FSS.




                                          Page 15                                                     GAO/HEHS-97-60 Pharmaceutical FSS
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In February 1995, VA presented to GSA its analysis of the potential effects of
opening the pharmaceutical schedule on FSS prices and VA drug costs
taking into consideration the protection the Veterans Health Care Act
gives VA against drug price increases. On the basis of discussions with
representatives of numerous drug manufacturers, VA made two key
assumptions in its analysis about the potential effects of opening the
pharmaceutical FSS: (1) drug manufacturers would eliminate FSS pricing for
all drugs not covered by the Veterans Health Care Act, forcing federal
purchasers to buy these generic drugs at higher wholesale prices, and
(2) FSS prices for all drugs covered by the act would rise to their ceiling
prices.34

VA applied those two assumptions to drug purchases it made during the
first 6 months of 1994.35 According to VA, it spent about $37.8 million on
4,877 generic drugs not covered by the act. If it had purchased the same
drugs at wholesale rather than FSS prices, VA estimated that it would have
paid over $79.7 million, about 111 percent more. In the same period, VA
spent about $118.3 million on 911 brand-name drugs that were covered by
the act and that had FSS prices below their federal ceiling prices. Had the
manufacturers of those drugs raised the FSS prices to the ceilings, VA
estimated that it would have paid over $152.9 million, roughly 29 percent
more. Thus, VA calculated that on an annualized basis, the impact of giving
state and local governments access to the FSS would have been a
$153.1 million increase in its own yearly drug expenditures because it
would have to pay about 49 percent more overall for the drugs included in
its analysis.

Those federal purchasers that, unlike VA, have no protection from the
ceiling prices established by the Veterans Health Care Act would pay full
FSS prices on all drugs they buy from the schedule.36 Currently, however,
most manufacturers’ FSS prices do not exceed the ceiling prices. In fact, as
of November 1996, only 25 of 162 drug manufacturers had FSS prices that
were above the federal ceiling prices. But manufacturers can offer


34
 DOD and Indian Health Service officials agreed with VA’s assumptions about the potential effects of
opening the schedule.
35
 According to VA, calculations were based on actual contract purchase prices from VA’s prime vendor
network from Jan. 1 through June 30, 1994.
36
  Any federal purchaser may contact drug manufacturers and attempt to obtain FSS price reductions
on specific products before placing orders from the schedule. Manufacturers are allowed to provide
such reductions without passing them on to other federal purchasers or changing a product’s listed
FSS price. According to a VA official, however, drug manufacturers typically do not provide FSS price
reductions without providing them to all federal purchasers.



Page 16                                                     GAO/HEHS-97-60 Pharmaceutical FSS
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                                          purchasers not protected by the act prices above the ceilings.37 Officials
                                          representing several drug manufacturers told us manufacturers would
                                          consider this option attractive if the pharmaceutical schedule is opened
                                          because they could then offer these higher prices to state and local
                                          purchasers. The federal purchasers that are not protected by the ceiling
                                          prices would then also pay the full price increases when purchasing from
                                          the schedule.

                                          The potential impact of FSS price increases on different government
                                          purchasers when purchasing from the pharmaceutical schedule is
                                          summarized in table 1.

Table 1: Potential Effects of FSS Price
Increases on FSS Prices Paid by                                                     FSS price paid
Government Purchasers                     Purchaser                  Before FSS opened After FSS opened                 Implications
                                          VA, DOD, Public       Lower of FSS or               Lower of FSS or           FSS price for 8% of
                                          Health Service, Coast federal ceiling price         federal ceiling price     drugs could
                                          Guard                 for covered drugs;            for covered drugs;        increase up to
                                                                FSS for drugs not             FSS for drugs not         federal ceiling price;
                                                                covered                       covered                   FSS price could
                                                                                                                        increase for many
                                                                                                                        drugs not covered
                                          Other federal              FSS                      FSS                       FSS prices could
                                          government entities                                                           increase for many
                                                                                                                        covered and
                                                                                                                        uncovered drugs
                                          State and local            Not applicable—          FSS                       FSS prices, even if
                                          government entities        negotiated prices                                  they increase, could
                                                                                                                        be lower than prior
                                                                                                                        negotiated prices; if
                                                                                                                        they are not,
                                                                                                                        purchasers could
                                                                                                                        try to negotiate
                                                                                                                        lower prices
                                          Note: For the purpose of this table, federal purchasers are considered to be dependent on
                                          purchasing many of their drugs from the FSS rather than from alternative sources.




State and Local Purchasers                Opening the pharmaceutical schedule would give state and local
Could Choose Between                      purchasers the choice of buying drugs from the FSS or from other sources.
FSS or Other Drug Prices                  If a drug’s FSS price rises, public hospitals, for instance, could choose to
                                          buy it at the FSS price or continue to use group purchasing organizations,

                                          37
                                           About 72 percent of the drugs with FSS prices above FCP as of Sept. 30, 1996, had FSS prices that
                                          were less than 1 percent above FCP. According to a VA representative, many of these drugs’ prices
                                          probably would be at FCP if not for a minimal fee included in the price that covers VA’s administration
                                          of the FSS.



                                          Page 17                                                      GAO/HEHS-97-60 Pharmaceutical FSS
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    formularies, and other cost-control tools to attempt to negotiate a better
    price with drug manufacturers.38 The incentive for a drug manufacturer to
    negotiate a price below the FSS price would be limited, however, because
    the negotiated price could become the most-favored customer price and,
    thus, potentially affect the manufacturer’s FSS price negotiations with VA.

    The Public Hospital Pharmacy Coalition believes opening the schedule will
    benefit state and local purchasers because FSS prices will continue to
    represent a significant discount. The Coalition contends that drug
    manufacturers would have little incentive to raise FSS or other drug prices
    if the pharmaceutical schedule is opened because

•   a manufacturer’s participation in the cooperative purchasing program is
    voluntary, thus allowing a company to opt out of the program if it
    anticipates any adverse economic consequences;
•   if a manufacturer concludes that it must participate in the program for
    competitive reasons, the same competitive forces will keep prices from
    rising;
•   the potential size of the state and local market will be small based on the
    Coalition’s proposal for determining eligibility to access FSS drug prices;
    and
•   market size is but one of many factors drug manufacturers consider in
    developing drug pricing strategies.

    Therefore, the Coalition believes that any adverse effects on FSS or other
    drug prices would be negligible and state and local purchasers would have
    access to many FSS prices that would be lower than the drug prices they
    currently pay.

    A Coalition analysis of the differences between FSS prices and the prices
    nine public hospitals paid for drugs showed that, on average, FSS prices
    were considerably lower than the hospitals’ purchase prices.39 The
    analysis compared the prices for the 100 drugs each hospital spent the
    most on during a recent fiscal year.40 The Coalition concluded that FSS
    prices, on average, were lower than the hospitals’ purchase prices for
    about 83 percent of the drugs. The FSS price, on average, was about
    17 percent lower than the price the hospitals paid.

    38
     In addition to group purchasing organizations that represent hospitals, state and local agencies in
    more than 25 states have joined together to purchase drugs as a single group purchasing organization.
    39
      The analysis was based on FSS and hospital purchase prices as of Oct. 1, 1996.
    40
     Hospitals ranged in size from 140 to over 900 beds and included some that received price discounts
    on outpatient drugs because they serve a disproportionate share of Medicaid patients.



    Page 18                                                      GAO/HEHS-97-60 Pharmaceutical FSS
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                   Had those hospitals been able to buy their top 100 drugs at FSS prices
                   whenever the FSS price was below the hospitals’ regular purchase price,
                   they would have saved, on average, about 21 percent on drug
                   expenditures, the Coalition concluded.41 For those drugs with FSS prices
                   below hospital purchase prices, the average savings on total purchases of
                   a drug would have been about 25 percent.

                   If the pharmaceutical schedule is opened and FSS prices rise, the extent to
                   which state and local government purchasers could benefit is unclear. The
                   drug prices paid by the hospitals in the Coalition’s analysis show that
                   many FSS prices could rise and still be lower than what the hospitals have
                   paid. The extent to which FSS prices would increase, however, is uncertain.
                   In addition, if FSS prices increase because drug manufacturers raise prices
                   for their most-favored customers, the impact on state and local purchasers
                   could vary, depending on whether a state or local purchaser was a
                   most-favored customer. For each drug manufacturer, the most-favored
                   customer can vary by drug and by type of purchaser, such as a hospital,
                   health maintenance organization, or government purchaser. Therefore, in
                   those instances in which the state and local purchaser was a most-favored
                   customer, the negotiated price could rise. While an increase in
                   most-favored customer prices could affect state or local purchasers
                   differently, they would retain the freedom to try to negotiate better prices
                   for themselves. The result for federal purchasers, however, would be an
                   increase in FSS prices.


                   We received both written and oral comments on a draft of this report from
Agency Comments    GSA, VA, PhRMA, and the Public Hospital Pharmacy Coalition.
and Our Response
                   In general, GSA, VA, and PhRMA agreed that the report accurately reflected
                   the difficulty and complexity of assessing the potential effects of opening
                   the pharmaceutical FSS on schedule drug prices. PhRMA also commented
                   that the report provided important insights into characteristics of the
                   market that could be affected by such a change. However, PhRMA said that
                   in its view the report placed unnecessary emphasis on the Coalition’s
                   study and did not sufficiently analyze its flaws and limitations. We did not
                   provide a point-by-point analysis of each study mentioned in the report
                   because the purpose of this report was to provide an overall assessment of
                   the potential effects of opening the pharmaceutical FSS.



                   41
                    Total expenditures for each hospital for the top 100 drugs at the lowest prices ranged from about
                   $345,000 to about $7.3 million.



                   Page 19                                                     GAO/HEHS-97-60 Pharmaceutical FSS
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The Coalition’s primary concern was that it believed the report
overemphasized the potential adverse effects of opening the schedule and
ignored potential competitive benefits. For example, the Coalition
believed that opening the schedule would create downward pressure on
FSS prices. The Coalition also said that drug manufacturers could absorb
any potential losses from providing lower drug prices to state and local
government entities. Moreover, the Coalition was concerned that the
report offered no real analysis of why FSS prices could increase and did not
emphasize that federal purchasers were not limited to purchasing
pharmaceuticals from the FSS. The Coalition contended that the Medicaid
rebate experience had minimal relevance to opening the FSS because the
FSS market would be much smaller than the Medicaid market and
participation in the cooperative purchasing program would be optional for
drug manufacturers. The Coalition also contended that because overall
drug prices did not increase after enactment of the Veteran’s Health Care
Act—which set price ceilings on certain drugs for VA and other
agencies—opening the pharmaceutical schedule would have little or no
impact on FSS prices. In addition, the Coalition recommended that we
delete any reference to diversion from the report because the diversion of
pharmaceuticals is already prohibited by the Robinson-Patman Price
Discrimination Act42 and the Non-Profit Institutions Act.43 The Coalition
also requested that we clarify GSA’s reasoning for proposing that the
pharmaceutical schedule be excluded from the cooperative purchasing
program. The Coalition strongly rejected GSA’s implication that a unique
relationship between the Veterans Health Care Act and the cooperative
purchasing program would cause an increase in FSS drug prices.

Throughout the report we emphasize that it is not possible to predict how
pharmaceutical FSS prices would change if the schedule is opened. In
response to the Coalition’s comments, we modified the report to
underscore this point. While we recognize that opening the FSS could
enable state and local government entities to purchase drugs at lower
prices, we focused on the potential for FSS drug prices to rise because it
was most relevant to GSA in determining whether to exclude the schedule
from the cooperative purchasing program. GSA has indicated that it is not
the intent of the cooperative purchasing program to increase schedule
prices. The report discusses the types of pressures that could potentially
result in increased FSS prices. We agree that federal purchasers can
purchase pharmaceuticals from sources other than the FSS and that the
extent to which federal purchasers buy products from other sources could

42
  June 19, 1936, ch. 592 (15 U.S.C. sec. 3-13c, 21a).
43
  May 26, 1938, ch. 283 (15 U.S.C. sec. 13c).



Page 20                                                 GAO/HEHS-97-60 Pharmaceutical FSS
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have an impact on schedule prices. Nevertheless, VA, which spends the
most federal dollars on pharmaceuticals, currently depends on the FSS for
most of its pharmaceutical purchases.

In our view, the Medicaid rebate experience provides a useful example of
how drug manufacturers have responded to requirements that they
provide lower prices to a significant share of the market and how FSS
prices could be affected if the size of the combined market represented by
federal, state, and local purchasers was also significant. The report
recognizes the uncertainty that exists about the size of this potential
market as well as the economic reasons why drug manufacturers would
not be likely to opt out of cooperative purchasing. While we agree that
overall pharmaceutical price changes following the Veterans Health Care
Act may be relevant in assessing the potential impact of opening the
pharmaceutical schedule, a better indicator would be changes in
pharmaceutical FSS prices following the act’s enactment. According to VA’s
fiscal year 1998 budget submission about 70 percent of all covered drugs’
prices have increased since then. Some VA officials believed that the
increase in FSS prices was the result, in part, of drug manufacturers
responding to the act’s drug pricing provisions, particularly those that set
price ceilings on certain drugs for VA and other agencies. These officials
also indicated, however, that the increase in FSS prices could be related to
other factors as well. In addition, we agree with the Coalition that federal
law already places restrictions on the resale or diversion of discounted
commodities purchased from the FSS. We included the issue in the report
because of the concerns raised by PhRMA and others. Moreover, the
Congress was sufficiently concerned about the diversion of outpatient
drugs to include specific safeguards against it in the Veterans Health Care
Act.44

In response to the Coalition’s comments, we added to the report GSA’s
specific justification for proposing that the pharmaceutical schedule be
excluded from cooperative purchasing. We agree that drug pricing
provisions in the Veterans Health Care Act alone or in combination with
other factors would not necessarily result in increased FSS drug prices. But
the federal price ceilings set in the act would be a factor in FSS
negotiations between VA and drug manufacturers and would be relevant to
the ultimate FSS prices different government purchasers could pay if the
pharmaceutical schedule were opened.



44
  See P.L. 102-585, sec. 602.



Page 21                                      GAO/HEHS-97-60 Pharmaceutical FSS
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           Each of the organizations provided a number of suggested technical
           changes that we incorporated into the final report where appropriate.


           We will make copies of this report available upon request. This report was
           prepared by John Hansen, Assistant Director, Joel Hamilton, Leslie Albin,
           and Toni Navarro. Please call me at (202) 512-7119 or Mr. Hansen at
           (202) 512-7105 if you or your staff have any questions about this report.




           Bernice Steinhardt
           Director, Health Services Quality
             and Public Health Issues




(108294)   Page 22                                     GAO/HEHS-97-60 Pharmaceutical FSS
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