Medication rebates are by now a time-honored part of employer-sponsored health insurance. How do they work? Let’s assume a drug costs $100. A substantial fraction of that, as much as $66 or more in the case of insulin, goes not toward the cost of the production of the drug, nor for pure profit on the part of the manufacturer, but back as a “rebate” to you, the employer (~90% on average, according to CVS and Express Scripts) and to the pharmacy benefit manager (PBM).

Let’s examine the incentives at work in this system. Imagine that KBGH Project Manager Matt Thibault were to invent a magically effective new cardiovascular drug tomorrow that cost only $2 per dose. This drug would soon be in the hands of every high-risk cardiovascular patient in America, right? Maybe not. At a price of $2, no PBM would likely be interested in having the drug on formulary because the potential for the PBM to make money off the drug in the form of rebates (or, for that matter, on spread pricing, a topic for another day) is tiny; any percent of $2 is a small amount of money.

Make that same drug $20 per dose and offer a 50% rebate split between the PBM and the employer, though, and now we’re getting somewhere. PBMs routinely move drugs up the formulary list in exchange for greater rebates. This has led to rebates being renamed, perhaps more accurately, as “kickbacks.” The incentives are aligned, then, to make sure the drug is as expensive as possible in order to maximize kickbacks to the PBM.

It would be one thing if consumers at the retail pharmacy level could see this happening and make a decision on where to buy their medications. But rebates are strictly confidential (although that may change soon). In order to keep rebates secret, PBMs also have to keep net prices—the cost of the drug after applying the rebate–confidential. To avoid having to say what the net price is, insurers typically require anyone with coinsurance to pay for a percentage of the retail pharmacy list price, not the secret net price.

It isn’t hard to predict where this system ends up. Drugs inevitably get more expensive, PBMs make more money than the drug companies they ostensibly help with supply chain issues, and patients (a.k.a., your employees) bear the burden in the form of increased list prices. A recent study in JAMA Health Policy (paywall) bears this out.

Investigators estimated the effective out-of-pocket share of drug costs that would have been paid by a hypothetical patient from 2014 to 2018, taking into account both initial coverage, a “coverage gap” (as in Medicare Part D), and a catastrophic coverage phase. In the study years, the average list price–what the drug costs, rebate included–per unit increased 29%. The average net price–the cost of the drug after applying the rebate–increased only 7%. The huge divergence between list and net prices was completely due to a 98% increase in average rebates.

This astonishingly high list-to-net ratio grew fastest for drugs with branded and generic competitors, from 2.7 in 2014 to 3.4 in 2018. The list-to-net ratio grew, but more slowly, for drugs with branded competitors only (from 1.4 to 1.6) and drugs without any competition (from 1.2 to 1.4). So we have yet another example in the paradoxical medical economy in which competition, rather than decreasing cost to the consumer, increases cost to the consumer (again, a topic for another day).

Americans do not overconsume medical resources. American health care is expensive almost exclusively because of flawed pricing structures. We simply pay more for any given service, medication, or outcome than people in peer countries do. Yet almost every intervention employers implement is designed to reduce consumption, and relatively few interventions are aimed at pricing. Rebates inherently increase the price of medications to the consumer and inevitably lead to less adherence to prescribed medications.

So don’t wait for new PBM transparency laws to take effect. Have a frank conversation about how you want medication prices to work in your employee health plan. A simple first step that doesn’t go all the way to a pure, “pass-through” PBM relationship, is to tell your insurer that you want to include “point-of-sale rebate pass-through” with your plan. This would pass the rebate payment through to the consumer (your employee) at the point of sale, reducing their out-of-pocket obligation by ensuring that their coinsurance applied only to the net price. Your employees will thank you.

As the Medical Director of the Kansas Business Group on Health, I’m sometimes asked to weigh in on hot topics that might affect employers or employees. This is a reprint of a blog post from KBGH.