Why HHS is Right on Rebates

Killing PBM rebates could lower drug prices without hurting R&D

Update: The Trump Administration withdrew this HHS proposal on July 10th, 2019.

People are paying more for drugs, even as inflation and production costs fall. However, many politically-popular tactics to lower prices could hit R&D budgets — the lifeblood of new medicines.

In a proposal to lower prices out tonight, the Dept. of Health and Human Services (HHS) instead goes after “significant distortions in the drug distribution chain” that increase out-of-pocket costs.

The HHS solution: kill the sketchy rebates drug companies pay to pharmacy benefit managers (PBMs) for higher placement on formularies.

Already confused? That’s what PBMs want. Let’s break it down.

What’s a formulary?

A formulary is a list of drugs that doctors use to determine prescriptions. The higher a drug is on a formulary, the more it’s prescribed.

The order of drugs on a formulary is determined by the insurer that pays for those drugs — and by the PBM that negotiates on the insurer’s behalf.

What’s a PBM?

PBMs negotiate for insurers to extract lower prices from drug companies.

Example: Cigna (PBM) tells Sanofi (drug company) that Medicare (insurer) will list Sanofi’s Lantus (drug) higher up on its formulary — if Sanofi sells Lantus to Medicare for less than its current price.

As Sanofi wants a more favorable formulary, it also pays Cigna a juicy rebate.

How does this affect what people pay?

Sanofi says yes to Cigna, because Sanofi wants doctors to look at Medicare’s formulary and prescribe Lantus rather than a rival drug. Sanofi sells more Lantus, Cigna gets a rebate, and Medicare pays less for each prescription.

But that discount is barely passed on to patients because the insurer, the PBM, and often even the patient’s hospital each take a cut.

Don’t actual people still get part of the discount?

Ideally, yes — but Sanofi isn’t satisfied to just sell more Lantus, because it’s earning less per dose. So Sanofi raises the list price of Lantus and pays Cigna an even juicier rebate to keep Lantus above other drugs on the formulary.

Medicare still gets a discount, but now the benefit passed on to the patient has been overridden by the net price increase — so all-in-all the patient pays more.

A vicious cycle ensues: PBMs get higher rebates for higher prices, insurers and hospitals profit, and patients pay the price. Rebates incentivize price increases and enrich extraneous middlemen: the PBMs.

How did this happen?

The rebates paid by companies like Sanofi to PBMs like Cigna should be illegal under the Social Security Act, which permits discounts (like a markdown on the price of a drug when a patient buys it at CVS), but forbids kickbacks.

However, PBM rebates are exempted from anti-kickback laws by a so-called “safe harbor” provision, which says rebates are legitimate discounts. Why are rebates exempted? PBMs hired great lobbyists when the rules were drafted.

How does the HHS proposal fix this?

The new proposal eliminates the safe harbor for PBM rebates. This change comes down to a single footnote: “Rebates paid by drug manufacturers to or through PBMs to buy formulary positions… do not qualify as ‘a discount.’”

This interpretation excludes PBM rebates from the “safe harbor,” exposing companies that pay rebates (and PBMs that take them) to liability for violating anti-kickback laws, because rebates really are kickbacks.

Will this actually lower drug prices?

Fewer rebates mean fewer goodies for PBMs at the expense of patients. While it wouldn’t stop rebates altogether, nor single-handedly solve drug pricing, it may be an effective strategy to lower prices without pressuring R&D budgets.

PBMs, which would get a fixed fee for their services rather than profiting from price increases, may work with insurers to raise premiums. However, even if they do, the net effect should be a reduction in total patient drug spending.

The next step?

Kill PBMs altogether.


To turn a complex process into a 3-minute read, I’ve made several serious simplifications such as excluding distributors. Check out the HHS proposal for the full story.

Principal at RA Capital, on the boards of 7 biotech companies. Founder/CEO of Nivien Therapeutics. Australian-American. 50 countries and counting.

Principal at RA Capital, on the boards of 7 biotech companies. Founder/CEO of Nivien Therapeutics. Australian-American. 50 countries and counting.