American’s are fascinated by Canadian drug prices. The Great White North is seen by many as the home of reasonably priced pharmaceuticals. Much of that is due to having provincial health care plans with purchasing and regulatory clout that dictate prices. Now Ontario is aiming for lower prices of generic drugs by trying to restrict a particular type of supply chain contract. As the Globe and Mail explains (A bitter pill to swallow, Apr 17), the contracts in question involve professional allowances:
The fight with the province over drug prices has exposed a business model that the pharmacy industry has counted on for decades. Ontario plans to eliminate professional allowances – payments that generic drug manufacturers make to pharmacies as an incentive to use their products over those made by a rival drug company. These payments, which amount to hundreds of millions of dollars a year for the retailers, are how the pharmacy operations of most drugstores make their profits. But while some drugstores call the payments rebates, the Ontario government says they inflate drug prices, and eliminating them will cut its annual generic drug tab of more than $1-billion in half.
A CBC report has a little more detail on these allowances (‘Professional allowances’ and the price of generic drugs, Apr 9):
What are “professional allowances?” It depends who you ask. Ontario Health Minister Deb Matthews compared the payments to “kickbacks” that generic drug makers pay to pharmacies so they will stock their products. Drug prices are regulated. When Ontario last changed the rules on generic drug pricing, in 2006, it said generics could be priced at no more than 50 per cent of the price of their brand-name counterparts. It also said drug companies could not offer pharmacies discounts off the invoice price to encourage them to carry their products. That practice is allowed in several other provinces. Ontario did allow the drug companies to provide “professional allowances” to pharmacies — but only under strict guidelines. The money is supposed to be used for direct patient care.
So what counts as “direct patient care”? It is supposed to be things like delivering drugs to seniors or running a flu clinic. The province’s gripe is that the money isn’t being used as its suppose. According to the CBC,
The province argues that they’re subject to abuse and they keep generic drug prices artificially high. Among the problems the health ministry says its audits have found are:
- Pharmacy owners have reported that 70 per cent of professional allowances have gone toward fringe benefits, bonuses, overhead costs and boosting profits instead of patient services.
- As many as 100 individual pharmacy owners have failed to disclose any documentation related to professional allowances collected, and over 650 provided incomplete reports in 2009.
- At least one pharmacy and wholesalers have been involved in a “resale” scheme that triggered the payment of professional allowances multiple times for the same product.
The next question to ask then is just how important they are to pharmacies. The pharmacies claim that they are very, Very IMPORTANT.
Generic drug makers offered pharmacies rebates of as much as 80 per cent off the wholesale price, to entice them to carry their products, the bureau reported. The average rebate was about 40 per cent, but major chains use their buying clout to get bigger discounts.
The Globe and Mail also quotes one pharmacy manager claiming that her small stored got about $300,000 in allowances and that the store wasn’t particularly profitable. The same article reports that allowances are also paid on drugs covered by private insurance and that the payments can be substantial:
Industry figures collected by the government and obtained by The Globe and Mail reveal just how lucrative the private drug plans are for pharmacies. One unidentified pharmacy last year collected $6.4-million in allowances from generic manufacturers for four drugs that cost $5.9-million, the figures show. In one instance, the pharmacy received an allowance that was more than three times higher than the cost of the drug itself.
Of the $1.48-billion that manufacturers paid in allowances to pharmacies in 2008 and 2009, just under 80 per cent, or $1.2-billion of the total, was for drugs not funded by the province. They represent about half of all prescriptions.
The pharmacies are responding to Ontario’s move by threatening to close store, reduce the number of pharmacists and technicians, and generally threatening to make the sky fall. The new regulations leave smaller pharmacies — which make most of their money on prescriptions as opposed to cosmetics and convenience items — particularly exposed.
So is there anything here? Will the province save money on drugs with this plan or will it lead to less convenience for customers or both? First, let me say that these professional allowances seem awfully similar to slotting allowances, the lump sum fees that packaged goods makers have made to supermarkets in order to gain distribution for their goods. Now many people have argued that slotting allowances are open to abuse and it seems the same can be said for professional allowances. There seems to be every reason to use them as a way to skirt regulation. They also seem to matter in terms of who gets distribution. One pharmacy manager told the Globe and Mail:
Ms. Winn admits its one of the few ways drugstores choose a supplier. “They’re all the same price,” she says of the generic drugs, which are made identically. “So as the pharmacist, you pick the one that either you like the person that is calling on you, or you like the reputation of that company.” And the amount a company is willing to rebate, anywhere between 10 and 60 per cent at her stores, Ms. Winn estimates, is often a deciding factor.
Now it seems that the province should see lower prices if these allowances go away. The generic drugs are interchangeable commodities and should nearly at cost if there is retail competition. If the suppliers pay a lump sum upfront, they need a higher wholesale price to recoup that amount and still break even but that leads to less intense retail competition (which the pharmacies like). Combined with the allowance, retail profits then rise.
Before any grad students get excited about trying to formalize that argument, they should know that Greg Shaffer at Rochester has beaten them to the punch. Shaffer also shows that allowing these lump sum fees lowers social welfare. Said another way, his analysis backs the Ontario regulators.
That said, Shaffer’s model ignores investments in retailing — things like maintaining network store or being open long hours. Those obviously provide convenience to customers. If pharmacies cut back enough, the provincial government’s savings could be funded by increased personal costs incurred by provincial residents. That said, I suspect that the existing equilibrium results in an over-investment in retailing — i.e., it is currently too easy to get to the drug store. My logic is that big allowances are going to go to stores that have big installed bases of customers. Since most of the customers are not paying for the drugs themselves (beyond, perhaps, some co-pay), a pharmacy builds a customer base by competing on non-price factors. Thus, there is a reason to go beyond an efficient level of service.