Pharmaceutical Costs: A Comparison of Department of Veterans Affairs (VA), Medicaid, and Medicare Policies

Prepared for Members and Committees of Congress

The Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (MMA) (P.L.
108-173) addressed seniors’ rising out-of-pocket costs of prescription drugs by providing a
mechanism for beneficiaries to obtain affordable prescription drug insurance coverage. The
Medicare prescription drug benefit, otherwise known as Part D, was designed to take advantage
of market competition. In accordance with market competition principles, the drug plans that
administer the drug benefit are corporations who may rely on rebate negotiation and price-volume
discounts as a way to affect prices.
A provision in the MMA, termed the “noninterference” provision, prevents the federal
government from acting as a third party by negotiating the prices that the drugs plans would pay
to pharmaceutical manufacturers. Both the new Speaker of the House and new Senate Majority
Leader have reportedly expressed their support for repealing the “noninterference” provision, and th
regard it as a priority for consideration in the 110 Congress. Should the provision be repealed,
Congress may wish to provide guidance on how it expects prices to be negotiated. In order to
clarify and inform the debate, this report provides an overview of the pharmaceutical pricing
policies used by the Department of Veterans Affairs (VA) and Medicaid—the largest federal
purchasers of prescription drugs, other than Medicare.
The Veterans Health Administration (VHA) operates the nation’s largest integrated direct health
care delivery system. Unlike Medicare, which operates as an insurer by reimbursing beneficiaries
for the cost of medical care provided by doctors and other providers in private practice as well as
by private and public hospitals, VHA provides care directly to veterans largely in VA clinics and
VA hospitals. Currently VA utilizes four contracting mechanisms to acquire its pharmaceutical
supplies: (1) the Federal Supply Schedule (FSS); (2) performance based incentive agreements; (3)
pricing under the Veterans Health Care Act of 1992; and (4) National Standardization Contracts.
Medicaid, a state administered program that operates under broad federal rules, directly controls
drug prices by putting a federal ceiling on reimbursements for drug products available from
multiple sources and by requiring drug manufacturers to pay rebates to states for drugs purchased
on behalf of Medicaid enrollees. States further control overall drug costs through multiple
methods, including using formularies and preferred drug lists, requiring that Medicaid enrollees
make copayments, and requiring generic substitution.
Several options exist for affecting out-of-pocket and overall prescription drug costs, including (1)
establishing a federal price ceiling for Medicare (like Medicaid); (2) mandating that
manufacturers provide larger rebates to Part D plans (like Medicaid); or (3) establishing a
Medicare pharmacy purchasing system (like the VA).

Introduc tion ..................................................................................................................................... 1
Drug Prices Versus Formularies................................................................................................2
Medicare Pharmaceutical Pricing....................................................................................................2
Medicare Formularies...............................................................................................................3
Negotiati on ................................................................................................................................ 4
Possible Ripple Effects.......................................................................................................4
The VA Pharmaceutical Purchasing System....................................................................................6
Federal Supply Schedule (FSS)..........................................................................................7
Performance-based Incentive Agreements (Blanket Purchase Agreements)......................8
Pricing under the Veterans Health Care Act of 1992..........................................................8
National Standardization Contracts....................................................................................9
Formulary Management in the VA................................................................................................10
Restrictiveness of VA’s National Formulary......................................................................11
Non-formulary Requests....................................................................................................11
Medicaid Pharmaceutical Pricing...................................................................................................11
Federal Upper Limits........................................................................................................12
Medicaid Rebates..............................................................................................................13
Medicaid Formularies.......................................................................................................13
Negotiating Drug Prices for Medicare..........................................................................................13
Option 1: Establish a Medicare ceiling price....................................................................14
Option 2: Mandate that Manufacturers Provide Rebates to Part D Plans.........................14
Option 3: Establish a Medicare Pharmacy Purchasing System........................................15
Table 1. Comparison of Medicare, VA, and Medicaid Drug Programs...........................................5
Author Contact Information..........................................................................................................15

One of the motivating factors for Congress to create Medicare Part D in the Medicare
Prescription Drug, Improvement, and Modernization Act of 2003 (MMA) (P.L. 108-173) was
seniors’ rising out-of-pocket drug costs. Prior to MMA, 38% of Medicare beneficiaries did not 1
have drug insurance coverage. People without sufficient drug insurance were paying drug prices 2
that were 15% higher on average than the prices paid by insurance companies. Some Medicare
beneficiaries who did not have drug insurance coverage coped with these higher prices by filling
fewer of their prescriptions and taking medications less frequently than their doctors 3
Medicare Part D provides voluntary insurance coverage of drugs for beneficiaries, albeit at a high 4
price to the federal government. The federal cost of Part D benefits is estimated to be $44.7 5
billion in 2007. Medicare Part D was designed to take advantage of market competition. In
accordance with market competition principles, the drug plans that administer the drug benefit are
corporations who may rely on rebate negotiation and price-volume discounts as a way to affect
A provision in the MMA, termed the “noninterference” provision, prevents the federal
government from being a third party in drug price negotiations between the Part D drug plans and
pharmaceutical manufacturers. Both the new Speaker of the House and new Senate Majority
Leader have expressed their support for repealing this “noninterference” provision, and regard it th6
as a priority for consideration in the 110 Congress. Furthermore, one poll indicates that about

85% of Americans also seem to support repealing the provision and allowing the government to 7

negotiate prices.

1 For more statistics on drug coverage in the Medicare population from 1996-1999, see Mary A. Laschober, Michelle
Kitchman, et al., “Trends in Medicare Supplemental Insurance and Prescription Drug Coverage, 1996-1999,” Health
Affairs, February 2002, W127-138.
2 From the Report to the President: Prescription Drug Coverage, Spending, Utilization, and Prices (Washington:
DHHS, April 2000).
3 One study found that Medicare beneficiaries with drug coverage were 6%-17% more likely to fill their prescriptions
and medicate than beneficiaries without drug coverage. For more information on this statistic and others, see Bruce
Stuart and James Grana,Ability to Pay and the Decision to Medicate,” Medical Care, vol. 36, no. 2 (February 1998),
p. 202-211.
4 For more information about MMA, see CRS Report RL31966, Overview of the Medicare Prescription Drug,
Improvement, and Modernization Act of 2003, by Jennifer O’Sullivan et al.
5 For more details, see the March 2006 Baseline Budget Projections from the U.S. Congressional Budget Office,
available at Although more recent CBO budget projections
are available for aggregate Medicare spending, the March 2006 baseline contains the most recent detailed projections
for Medicare Part D.
6 For more details, see press release from the Senate Democratic Communications Center, “Reid: Congress Must
Improve Medicare Part D,” December 8, 2006; see also Drew Armstrong, “Democrats’ First 100 Hours: Big Pharma
Braces for Heavier Federal Hand in Drug Pricing Policy,CQ Weekly, November 20, 2006; See also Rebecca Adams,
“Pharma Braces for Battle,” CQ Weekly, November 27, 2006. On January 12, 2007, the House of Representatives
passed H.R. 4 on a 255-170 vote. H.R. 4 requires the Secretary of HHS to negotiate Medicare drug prices. On April 12,
2007, the Senate Finance committee reported S. 3, which repeals thenoninterference” provision, as well as provisions
on data transparency and comparative clinical effectiveness research. Neither H.R. 4 nor S. 3 permits the Secretary to
establish a formulary for Medicare Part D.
7 A poll by the Harvard School of Public Health and Kaiser Family Foundation indicates that 85% of adults (92% of
Democrats, 85% of Independents, and 74% of Republicans) support allowing the federal government to negotiate drug

Should the “noninterference” provision be repealed, Congress may wish to provide guidance on
how they expect the Secretary of Health and Human Services (HHS) to negotiate prices. A debate
could occur about the options and mechanisms of a new drug pricing policy for the Medicare
drug plan. In order to clarify and inform the debate, this report provides an overview of the
pharmaceutical pricing policies used by the Department of Veterans Affairs (VA) and Medicaid—
two of the largest federal purchasers of prescription drugs, other than Medicare. This report first
provides a brief background of the current U.S. pharmaceutical pricing for Medicare, and the
implications of this policy. The report then discusses the types of pricing policies used by the VA
and Medicaid to stem the rise in drug expenditures. The report concludes by discussing the
implications of negotiating drug prices and options that may lower costs for the Medicare Part D
Program and its beneficiaries.
Prices and formularies are often perceived to be intertwined because formularies are the most
frequently used incentive in drug price negotiations. Importantly, other “carrots and sticks” may
be available to drug price negotiators, and an open formulary does not necessarily preclude price
negotiation. A formulary is a set of drugs for which a Part D drug plan, or other health insurer, has 8
agreed to pay a portion of the costs; the formulary may also specify contingencies for payment.
Drug pricing policies do not dictate formularies. A drug pricing policy may have no bearing on
which drugs will or will not be included in a formulary. Adopting a drug pricing policy from
Medicaid, the VA, or even another country does not imply that the formulary is also adopted. In
contrast, knowing the extent to which a formulary will include or exclude pharmaceuticals may
help to determine which drug pricing policies would make the most sense. For example, if a
formulary was to include every drug on the market, a competitive bidding process would not be
the most sensible drug pricing policy, since those policies generally involve accepting the best bid
and rejecting the other bidders. In contrast, a competitive bidding process may be a reasonable 9
option for a formulary that only includes one drug in each drug class. However, simply having a
competitive bidding process for pharmaceutical pricing does not provide any information about
the inclusiveness of the formulary, because the resulting formulary may include one, two, or even
five drugs in each drug class.

Under current law, prescription drugs for Medicare beneficiaries are provided through
prescription drug plans (PDPs) and Medicare Advantage prescription drug (MA-PD) plans.
Unlike MA-PDs, which cover the costs of the entire set of Medicare benefits (Parts A, B, and D),

prices for the Medicare program. For more information, see The Henry J. Kaiser Family Foundation, “Public Sees
Health Care Prices as Unreasonable and Wants Government to Take Steps to Lower Them, December 8, 2006.
Available at
8 A drug formulary is a continually updated list of medications and related information, representing the clinical
judgement of physicians, pharmacists, and other experts in the diagnosis and/or treatment of disease.
9 For definitions of drug classes in the Medicare Part D program, see the CMS Medicare formulary guidelines,
available at, and the example
formulary, which is available at

the PDPs only cover the costs of prescription drugs (Part D).10 The plans have contracts with the
Centers for Medicare and Medicaid Services (CMS) to provide prescription drug coverage to
Medicare beneficiaries. Individually and with a great deal of flexibility, the plans construct
benefit packages (including the formulary, deductible, co-payments, and utilization management
tools), arrange a network of pharmacies to dispense the drugs, and negotiate prices and/or rebates 11
with the pharmaceutical manufacturers.
Enrollees are required to make copayments (which is the entire price if the drug is not covered12)
and pay premiums that may be affected by the negotiated prices (i.e., the lower the prices paid by
the plan, the lower the amounts the plan must charge in premiums). Beneficiaries’ satisfaction or
dissatisfaction with their drug plan is likely to be related to the amount they pay for drugs, among
other factors.
Part D plans are required to include two drugs in each therapeutic class, except if only one drug is
available. The CMS requires coverage of “all or substantially all” drugs for some mental
illnesses, including antidepressants, antipsychotics, and anticonvulsants. Anticancer drugs,
immunosuppressants, and HIV/AIDS drugs are also included in the “all or substantially all” list
of formulary drug classes. Plans can neither change their formularies without CMS approval, nor
drop coverage for persons currently using the drug, except at the beginning of the calendar year.
These minimum requirements do not imply that beneficiaries have access to every drug, or its
chemical equivalent, that they may be prescribed. For example, the MMA did not require Part D
plans to cover the costs of any drugs in the “doughnut hole”—the common term for beneficiaries’
drug expenditures between $2,400 and $5,451 in 2007. While a few plans are offering coverage 13
in the “doughnut hole” in 2007, most of this coverage is for generic drugs only. Moreover, any
system that grants patients the freedom to choose their own plan will have some inefficiencies,
namely that patients may not select the best plan for their needs. Nonetheless, polls indicate that 14
most patients are satisfied with their drug plans.

10 Part B also covers the cost of some drugs. For more information on Part B drugs, see CRS Report RL31419,
Medicare: Payments for Covered Part B Prescription Drugs, by Jennifer O’Sullivan.
11 For more information on PDPs, seeThe Nuts and Bolts of PDPs,” by Mary Ellen Stahlman, George Washington
University, National Health Policy Forum, Issue Brief no. 817, November 8, 2006.
12 A drug may not be covered if either the drug is not on the plans formulary or if a beneficiarys total drug spending is
in thedoughnut holethe common term for drug expenditures between $2,400 and $5,451 in 2007.
13 For more details, see the recent study by Jack Hoadley, Elizabeth Hargrave, Katie Merrell, Juliette Cubanski, and
Tricia Neuman, “Benefit Design and Formularies of Medicare Drug Plans: A Comparison of 2006 and 2007
Offerings,The Henry J. Kaiser Family Foundation, November 2006, available at
14 The satisfaction rate varies among polls. A poll conducted by the Henry J. Kaiser Family Foundation, Seniors Early
Experiences with Their Medicare Drug Plans (conducted June 8-18, 2006), indicated that 81% of beneficiaries are
very satisfied or “somewhat satisfied;” poll details are available at
Last accessed December 27, 2006. A Wall Street Journal Online/Harris Interactive Health-Care poll found that 75% of
beneficiaries are “very satisfiedor “somewhat satisfied. For more details see Harris Interactive, Seniors Satisfied with
Medicare Drug Plans; Seven in Ten Enrollees Say their Plan has Saved them Money on Prescription Drugs, November
20, 2006

A legal impediment to changing the way Medicare drugs are priced is the “noninterference”
provision in MMA. Specifically, this provision forbids the Secretary of Health and Human
Services (HHS) from negotiating the price of prescription drugs on behalf of Medicare 15
beneficiaries. The MMA states, “in order to promote competition under this part and in carrying
out this part, the Secretary—(1) may not interfere with the negotiations between drug
manufacturers and pharmacies and PDP sponsors; and (2) may not require a particular formulary 16
to institute a price structure for the reimbursement of covered Part D drugs.” The conference
report adds that, “conferees expect PDPs to negotiate price concessions directly with 17
manufacturers.” The pharmaceutical pricing policies discussed later in this report could not be
implemented in the Medicare program without allowing the Secretary of HHS, or some other
authority, to negotiate with the pharmaceutical manufacturers for Part D drugs.
Repealing the “noninterference” clause may lead to changing the drug pricing policy for
Medicare. If Congress repeals the provision and allows the Secretary of HHS to negotiate drug
prices, it may also wish to provide some guidance as to what type of drug pricing policy they
want the Secretary of HHS to negotiate and what the goals of such a pricing policy would be.
Since the number of different drug pricing policies is innumerate, examining policies that have
been applied in other settings may help in exploring the options.
In theory, the federal government may be able to leverage its market share to negotiate lower
prices. The extent to which the federal government could negotiate lower prices than the Part D
drug plans is unknown. In fact, some argue that market powers have already achieved lower 18
prices. Without more knowledge about the extent to which prices could be lowered, it is
impossible to predict whether a new pricing policy would lead to lower costs for Medicare
beneficiaries, the federal government, or other U.S. consumers.
Importantly, any new drug pricing policy for Medicare may have ripple effects on manufacturers’
research and development of new pharmaceuticals, Part D drug plans’ role and ability to compete,
pharmacies’ profits, as well as other U.S. consumers. The size of these ripples will depend upon
the type of pricing policy selected, and the extent to which the federal government negotiates

15 In October 2001, as the anthrax attack was unfolding on Capitol Hill, then-Secretary of Health and Human Services
(HHS) Tommy Thompson sought to purchase a large amount of the preferred antibiotic, ciprofloxacin (Cipro”) from
the manufacturer, Bayer Corporation, at a reduced price. Thompson made headlines with his negotiating tactics,
including a threat to override the drugs patent. The Strategic National Stockpile, the HHS program to assure treatments
for victims of bioterrorism and other emerging health threats, was established following an appropriation in FY1999,
and flowed from the Secretarys general authorities to control disease. Explicit statutory authority for the stockpile was
established in 2002 (P.L. 107-188). The authority of the Secretary to negotiate prices when procuring for the stockpile,
while not explicit in law, is implicit, and derives from his general authority to enter into contracts for goods and
services under federal programs.
16 Section 1860D(11)(I) of the Social Security Act.
17 For more information, see H.Rept. 108-391, p. 461.
18 For more information, see the January 10, 2007 letter from the Congressional Budget Office to the Honorable John
D. Dingell, Chairman of the House Energy and Commerce Committee, available at

lower prices. Possible implications, including the ripple effects from applying the VA or Medicaid
drug pricing policies to Medicare, are explored in the conclusions of this report.
In order to clarify some of the key differences between the Medicare, VA, and Medicaid systems,
Table 1 provides some details about the number of beneficiaries, costs, and certain elements of
these three federal programs.
Table 1. Comparison of Medicare, VA, and Medicaid Drug Programs
Medicare VAa Medicaid
Number of 22.5 million in PDPs 4.4 million VA 41.7 million with drug
beneficiaries or MA-PDs, pharmacy users in coverage in 200420
15.8 million in other 2006
drug insurance plans,
4.4 million did not
have drug coverage in
Federal $44.7 billion21 $3.4 billion $23.5 billion22
expenditures in
2006 (est.)
Percentage of 56.5% in PDPs, 68% 53.8%
prescriptions that 65.9% in MA-PDs23
are generic
Number of 780 million 120 million 584 million
prescriptions filled (in 2006)24 (in FY2006) (in 2005)

19 Of the 42 million Medicare beneficiaries, approximately 22.5 million were enrolled in Part D plans, as of June 11,
2006. The remaining 19.5 million beneficiaries either did not have prescription drug coverage (4.4 million), had
coverage from a Medicare-subsidized retiree plan (6.9 million), had coverage from a federal retiree plan (3.5 million),
or had other creditable drug coverage (5.4 million). Press Release from the CMS, June 14, 2006.
20 This number excludes 4.9 million Medicaid beneficiaries who are over age 65 since the elderly, beginning in 2006,
no longer receive drug coverage under the Medicaid program. CRS tabulations of data from CMS MSIS State
Summary Datamart.
21 March 2006 Baseline Budget Projections from the U.S. Congressional Budget Office, op. cit.
22 Medicare and Medicaid estimates from the Centers for Medicare and Medicaid Services, Projected National Health
Expenditures. Available at PhRMA member companies estimated
$164 billion in 2005 sales. For more details, see Pharmaceutical Research and Manufacturers of America (PhRMA),
PhRMA Membership Survey, 2006. Available at
23 Data from CMS Plan Reported Data (per 2006 Medicare Part D Plan Reporting Requirements) for the first two
quarters of 2006.
24 Data estimated by projecting the average monthly prescriptions filled for beneficiaries in PDPs or MA-PDs for
January-August 2006. Monthly prescriptions filled for beneficiaries available from CMS at

Medicare VAa Medicaid
Maximum $328.20 average $0 premium, $0 premium,
out-of-pocket costs annual premium, $8 for 30-day supply of $1 - $5 copays per 27
$265 annual drugs (for health prescription
deductible, conditions not
25% for costs connected to military
$265 - $2,400, service),
100% for costs $2,400 $960 annual limit, after
- $5,451.25, 5% for costs which the prescription
$5,451.26 and up.25 is free for Priority 26
Groups 2-6 veterans.
Appeals process for Physicians submit a declaration Physicians submit a States are required to have a
non-formulary stating that all covered Part D request stating that the prior authorization review
drugs drugs on any tier would not be as drug is medically process in place to consider
effective for the individual or would necessary. requests for non-preferred
have an adverse effect on the drugs.
individual or both. Plan makes
decision on appeal.
a. All VA data received directly from the Department of Veterans Affairs (VA).

Among those who have been arguing for the federal government to negotiate the prices of
prescription drugs under the Medicare Part D Program, considerable attention has been paid to 28
the VA pharmaceutical procurement model. Before discussing VA’s pharmacy procurement
system, it is essential to understand that the veterans health care system is an integrated (closed)
system, where physicians and other clinical staff are employees of the VA. Unlike Medicare,
which administers medical care through the private sector, the VA provides care directly to
veterans. The VA purchases its pharmaceutical needs directly from manufacturers and provides
prescription medications to veterans through its pharmacies and its own consolidated mail
outpatient pharmacy (CMOP) network. This closed system contributes towards successfully
implementing a national formulary, which does not exist in Medicare or Medicaid. The section
below discusses the VA’s contracting techniques used to purchase pharmaceuticals. That is
followed by an overview of VA’s formulary management process.
Currently, the VA utilizes four contracting mechanisms to acquire its pharmaceutical supplies: (1)
the Federal Supply Schedule (FSS); (2) performance-based incentive agreements, or Blanket

25 Cost-sharing amounts are those specified forstandard coverage.” Specific co-payments may vary by enrollee and
Part D drug plan.
26 VA provides a full prescription drug benefit including both formulary and non-formulary drugs. For a description of
priority groups see, CRS Report RL33409, Veterans Medical Care: FY2007 Appropriations, by Sidath Viranga
27 Amounts are for 2005. As of March of 2006, states have additional options for cost sharing for prescription drugs
that certain Medicaid beneficiaries can be charged. Those with income above 100% of poverty can have higher copays
for drugs as long as total aggregate cost sharing for all services do not exceed 5% of family income and as long as the
copayment amounts do not exceed between 10% and 20% of the cost of the drug (depending on family income and on
whether the state is using a tiered copayment system).
28Yes. Let the Government Bargain with Drugmakers,” The Philadelphia Inquirer December 6, 2006, Editorial, p.
A23; “Driving down Drug Prices,” The Boston Globe November 27, 2006, Editorial, p. A8; “Lowering Medicare Drug
Prices” The New York Times, November 14, 2006, Section A, p. 26.

Purchase Agreements (BPAs); (3) pricing under the Veterans Health Care Act of 1992 (P.L. 102-29
585); and (4) national standardization contracts. On a drug-by-drug basis, the VA selects the
mechanism that offers the lowest price.
The FSS is a price catalog that contains almost everything the federal government uses, from nuts
and bolts, to pharmaceuticals, to paper clips, to fire engines. The General Services Administration
(GSA) has delegated to the VA’s National Acquisition Center (NAC) the responsibility for the
FSS program for medical care related supplies, equipment, pharmaceuticals, and professional 3031
services. The FSS currently contains about 17,000 pharmaceutical products. Of this number,
about 36% are brand name drugs, and 64% are generic drugs. The FSS is open to all federal
agencies in the executive, legislative and judicial branches—including the VA, Department of
Defense (DOD), Public Health Service (PHS), Bureau of Prisons—and several other purchasers
including the District of Columbia, and Indian tribal governments. VA’s NAC Federal Supply
Schedule Service is responsible for establishing, soliciting, negotiating, awarding, and
administering the FSS. In general, FSS contracts are multi-year (minimum of five years) and
multiple award contracts, which means multiple companies supplying comparable products and
services, at varying prices, are awarded contracts.
VA’s NAC announces and posts solicitations that include all categories of commercially marketed 32
health care products including pharmaceuticals, grouped under Special Item Numbers (SINs). A
contracting officer evaluates each proposal based on the drug manufacturer’s discounting
policies. When evaluating proposals, discounting policies of the manufacturer’s competitors are
not considered. Under GSA procurement regulations, FSS prices for brand name drugs must be
no greater than the prices manufacturers charge their Most-Favored Customers (MFC) under 33
comparable terms and conditions. In general, MFC is the customer, or class of customers, which
receives the best discount and/or price arrangement on a given item from a manufacturer or
supplier. To help VA’s contracting officers determine the MFC pricing, pharmaceutical
manufacturers are required to provide VA a commercial price list for the proposed items, and are 34
also required to disclose their recent pricing granted to MFCs.
In general, when awarding a contract to a drug manufacturer, the VA’s NAC has to determine the
following: 1) whether the government was offered a fair and reasonable price; 2) whether the

29 Under its current contract with McKesson (the VA wholesale pharmaceutical distributor), the VA obtains an
additional 5% discount off the contract price for prompt payment.
30 VA NAC currently administers the following schedules: Pharmaceuticals; Medical Equipment and Supplies; Dental
Equipment and Supplies; Patient Mobility Devices; X-Ray Film, Equipment and Supplies; Diagnostic, Reagents, Test
Kits and Sets; Clinical Analyzer, Laboratory Cost-Per-Test; and Professional and Allied Healthcare Staffing Services.
31 The total number of products listed on the FSS is greater than 17,000 because FSS may list the same drug in different
dosage amounts, different dosage forms such as tablets and capsules, and package sizes.
32 Solicitation notices can be viewed at: Vendors can request a solicitation copy
by submitting a written request or by downloading solicitations from the VA at
33 See 48 C.F.R. §538.270.
34 The manufacturer must also provide a list that includes the following information for each item offered: (1) name of
the proposed item, this includes the generic name, trade/brand name; (2) proposed FSS price;( 3) proposed discount off
the commercial price list;( 4) either actual or estimated commercial annual sales for each item offered; (5) either actual
or estimated annual government sales for each item offered.

manufacturer is responsive and responsible; 3) whether the manufacturer completed all
certifications and regulatory requirements in their entirety; 4) whether the past performance
history of the manufacturer is satisfactory; 5) whether the manufacturer is financially capable;
and 6) whether awarding the contract to the drug manufacturer is in the overall best interest of the
Under each awarded FSS contract there is a Blanket Purchase Agreement (BPA) clause, which
allows the VA to further negotiate with the drug manufacturers and receive additional discounts.
The most commonly negotiated BPAs revolve around market share agreements such as a
commitment of the VA to buy a specific volume or quantity of drugs over a specified period of
time in exchange for receiving an additional discount. In general, BPAs differ from national 35
contracts (see below) because they are not competitively bid. The VA can also elect to include
one or more other FSS customers in a BPA. According to the VA, performance-based incentive
agreements provide an additional discount of 5%-15% off the FSS price.
The Omnibus Budget Reconciliation Act of 1990 (P.L. 101-508) required that pharmaceutical
manufacturers provide rebates to state Medicaid programs on outpatient drugs based on the
lowest prices the manufacturers charged their commercial and government customers. With the
passage of this legislation, drug manufacturers stopped giving discounts to many of their
government purchasers including the VA. In response, Congress enacted the Veterans Health Care
Act of 1992 (P.L. 102-585). Section 603 of this act required pharmaceutical companies to list 36
covered drugs on the FSS as a condition of continued participation in the Medicaid program. It
also required them to roll back price increases, and created statutorily mandated ceiling prices for
sales to the four largest federal purchasers of pharmaceuticals: the VA (including state veterans
nursing homes receiving grants under Section 1741 of Title 38, United States Code), DOD, PHS 37
(including the Indian Health Service), and Coast Guard. These four agencies are commonly
known as the “Big 4.” Furthermore, Section 603 of P.L. 102-585 required pharmaceutical
companies to adhere to the statutory requirements by signing a master agreement and 38
pharmaceutical pricing agreement.

35 In some circumstances BPAs are awarded after an abbreviated competition among FSS contractors with similar
36 Covered drugs are single source drugs, innovator multiple source drugs, and biological products. A single source
drug is a brand-name drug that is still under patent and thus is usually available from only one manufacturer. Under
Section 603 of P.L. 102-585, an innovator multiple source drug is a multiple source drug that was originally marketed
under an original new drug application approved by the Food and Drug Administration. This definition would include
multiple manufacturers’ licensed versions of a single drug that was granted a new drug application (NDA) approval.
The definition does not include true generics that were approved under an abbreviated new drug application (ADNA).
37 38 U.S.C. 8126(a).
38 The master agreement is a document that is signed by the manufacturer and the VA. The agreement contains
responsibilities of the manufacturer and the VA, and dispute resolution processes and terms of termination. The
pharmaceutical pricing agreement is an addendum to the master agreement that contains a complete list of a
manufacturer’s covered drugs and a federal ceiling price (FCP) for each drug. By signing the document the
manufacturer certifies the accuracy of all specified FCPs.

Under P.L. 102-585, pharmaceutical manufacturers agree to sell the “Big 4” agencies each
covered drug at no more than 76% of the non-federal average manufacturers price (non-FAMP), 39
minus any additional discounts as determined each year. Furthermore, under current law, when
the drug manufacturer raises the price of a drug faster than the rate of inflation based on the
Consumer Price Index (CPI), then the manufacturer must offer an additional discount, in an
amount that will ensure that the non-FAMP price does not exceed the percentage change in the 40
CPI. The federal ceiling price (FCP) is calculated using the following formula:
FCP = (annual non-FAMP x .76) - additional discounts
Under current law, manufacturers of covered drugs who do not offer their products on the FSS,
and who do not offer products under P.L. 102-585, are prohibited from contracting with the “Big 41
4” agencies and Medicaid. As stated before, the FCP is only available to the “Big 4”; other
federal agencies must pay the FSS price, which is higher if the manufacturer maintains a different
FCP and FSS price for the same covered drug. This is also known as “dual pricing.” Drug
companies can elect to have dual price lists, that is, to give federal ceiling prices to VA, DOD,
PHS, and Coast Guard, and provide negotiated FSS prices to all other federal customers. If the
pharmaceutical companies don’t elect to have dual prices, all FSS eligible federal customers will
receive the FCP. It should be noted that FSS prices could be lower than the FCP, and that the FCP
acts as a price ceiling and not a price floor. At present, 3,921 pharmaceutical products on the FSS
equal the FCP, and 1,897 drugs are below the FCP.
The VA also uses national standardization contracts to purchase pharmaceuticals. Depending on
what drug is purchased, other agencies such as DOD, PHS, and the Bureau of Prisons can
participate in these contracts. The Department seeks competitive bids from manufacturers for
products that are therapeutically equivalent within specific drug classes, and contracts with those
manufacturers whose products it believes provide the best value based on medical effectiveness,
safety and price, in exchange for including their products on the VA’s national formulary and 42
committing to use products throughout the VA health care system. These contracts are also
known as “committed use contracts” because the VA commits to use a specific drug instead of
another therapeutically interchangeable drug, and to guarantee drug companies a high volume of
use in exchange for lower prices. These are one-year contracts with the option to renegotiate the
contract. In FY2005, the VA purchased $446 million worth of pharmaceuticals through national
contracts. According to the VA, national contract prices are an additional 10%-60% lower than
the FSS prices.

39 Non-FAMP is the weighted average price paid by wholesalers, less any discounts, chargebacks, or similar price
reductions. These exclude prices paid by the federal government.
40 38 U.S.C. 8126 (c).
41 38 U.S.C. 8126 (a)(4).
42 Government Accountability Office, Prescription Drugs: Expanding Access to Federal Prices Could Cause Price
Changes, GAO/HEHS-00-118, p. 15.

It is important to understand the VA’s formulary management process because it has a direct
bearing on the purchasing mechanisms. Prior to 1995, the VA’s 156 medical centers managed
their pharmaceutical needs through individual formularies. The Department’s Drug Product and
Management division based in Hines, Illinois, managed and monitored drug usage and purchasing 43
for those facilities, but had no utilization oversight responsibilities. In September 1995, the VA
established a Pharmacy Benefit Management (PBM) Health Care Strategic Group, tasked with
establishing a national formulary, managing pharmaceutical costs, and overseeing pharmacologic 44
guideline development for common diseases within the VA health care system. In November
1995, as part of its reform efforts the VA created a nationwide system of Veterans Integrated
Service Networks (VISNs), consisting of 22 geographically defined networks, and each entity 45
was instructed to create a formulary. To develop their formularies each VISN generally
combined their medical center formularies, and on April 30, 1996, VISN formularies became
effective. To ensure that all veterans have access to pharmaceuticals—no matter where they live
in the U.S—the VA established a national formulary by combining the core of drugs common in
the VISN formularies. The national formulary took effect on June 1, 1997. The standardization
helped the VA lower its prescription drug costs through bulk purchases: “from a system
standpoint, this standardization not only defined the core national pharmacy benefits package, but
also provided leverage for bulk purchasing, and with that, contracting within drug classes when 46
appropriate.” According to the VA, the overall strategy of creating a formulary process is to
create a comprehensive pharmaceutical benefit offered to all VA patients seeking care in the VA.
VA’s PBM continuously reviews formulary decisions to ensure that patients achieve the desired
The VA’s formulary management process involves the VA Medical Advisory Panel (MAP), the
VISN formulary leaders committee, VA’s clinical subject matter experts, and the VA PBM staff.
The MAP consists of 12 field-based practicing physicians, one DOD physician, and six clinical
pharmacists. The PBM staff’s role is facilitative, except for clinical subject matter specialists who
provide input when selecting drugs. Based on input from the above-mentioned stakeholders, VA’s
PBM reviews pharmaceutical purchases and identifies high-usage pharmaceutical items. The
team reviews these products based on patient treatment, treatment protocol, and patient outcome.
Currently, the VA formulary consists of 1,294 chemical entities, many of which are available in
more than one dosage form. These chemical entities represent 4,778 specific drug products
dispensed by the VA. For instance, the VA formulary has a single entry for the chemical entity 47
felodipine, a drug used to treat high blood pressure. However, VA dispenses three dose-specific
formulations of felodipine; 2.5mg tablets, 5mg tablets and 10mg tablets. Of the total number of
drugs on the formulary, 44% are brand-name medications and 56% are generic drugs. Based on

43 Mariscelle Sales et al., “Pharmacy Benefits Management in the Veterans Health Administration: 1995 to 2003,” The
American Journal of Managed Care, Vol. 11, no. 2 (Feb. 2005), p.104.
44 Ibid., p.105.
45 On January 23, 2002, the VA announced the merger of VISN 13 and 14 into a new VISN 23; currently VHA is
composed of 21 VISNs.
46 Ibid., p. 106.
47 Felodipine is an oral calcium-channel blocker (CCB) of the dihydropyridine (DHP) class. By blocking calcium,
felodipine relaxes and widens (dilates) blood vessels so blood can flow more easily. Lowering high blood pressure
helps prevent strokes, heart attacks, and kidney problems.

the amount of drugs dispensed (30-day equivalent prescription volume), VA dispenses about 68%
generic drugs and 32% brand-name drugs.
There have been several recently published reports stating that the VA national formulary is
overly restrictive and that applying a “VA-style formulary process to the Medicare prescription 48
drug program would significantly reduce physician and patient choice of drugs.” Furthermore,
some reports have stated that the drugs used in the VA health system are older than the drugs used 49
in the rest of the U.S. health care system. However, in a previous study the National Academy
of Sciences found that the “VA national formulary was not overly restrictive, and the limited
available evidence suggests that it has probably meaningfully reduced drug expenditures without 50
demonstrable adverse effects on quality.” Moreover, the VA has provided its clinicians
guidelines on prescribing non-formulary drugs to veterans when it is medically necessary.
According to the VA guidelines, each VISN must have in place an evidence-based and timely
process for approving expeditiously the use of non-formulary drugs by local physicians. In
general, non-formulary requests are reviewed and the requester is notified of the decision within 51
96 hours of the receipt of a complete non-formulary request. The VA guidelines state that “as
always, the prescriber must use his or her best clinical judgment when selecting the most 52
appropriate pharmacotherapy for a specific patient in a specific clinical situation.”

Medicaid is composed of 50 state (and the District of Columbia) administered programs that
provide coverage of health care services, including pharmaceuticals, to certain low-income
individuals. The state programs operate independently under broad federal guidelines. The states
and the federal government, however, share in the cost of each program based on a statutory
formula. The federal share of program expenditures, subject to both a federal floor and ceiling,
ranged, in FY2006, from a low of 50% to a high of 76%. For each $1 of state spending on
Medicaid services, a state is able to claim a federal matching payment of $1 to $1.52.

48 The Pharmaceutical Research and Manufacturers of America (PhRMA), Comparison of Compounds on the
Formularies of Medicare Prescription Drug Plans (Pdps) and the Department of Veterans Affairs Veterans Health
Administration (VA) National and Regional Formularies, December, 2006, p. 11, available at
files/VHAWhitePaperDec2006Final.pdf accessed January 6, 2007.
49 Frank R. Lichtenberg, “Older Drugs, Shorter Lives? An Examination of the Health Effects of the Veterans Health
Administration Formulary, The Manhattan Institute, Medical Progress Report, no. 2, Oct. 2005.
50 Blumenthal, D. Herdman R., eds; VA Pharmacy Formulary Analysis Committee, Division of Health Care Services,
Institute of Medicine. Description and Analysis of the VA National Formulary. Washington, DC: National Academy
Press; January 2000.
51 Department of Veterans Affairs, Veterans Health Administration, VHA DIRECTIVE 2001-044, VA NATIONAL
52 Ibid.

Reimbursement levels for all Medicaid covered items and services, including prescription drugs,
are set by the states. Unlike many other Medicaid items and services, however, prescription drug
prices are subject to upper limits established in federal law that restrict the amount of federal
matching payments available for those products. In addition, federal law also requires
manufacturers whose drugs are made available to Medicaid beneficiaries, to pay rebates to states.
The Medicaid rebates were established to achieve a “best price” policy—based on the philosophy
that Medicaid as a health coverage program of last resort should have access to the lowest prices
offered to other drug purchasers in the market.
In addition, states can and do aggressively negotiate for lower Medicaid drug prices. Many states
administer their own upper limit payment formulas, generally intended to keep prices below the
federal upper limits. Many states also have negotiated supplemental rebates, over and above those
required under federal law. These rebates are often related to the state formularies. For example,
under Florida’s Medicaid supplemental rebate program, manufacturers that agree to pay the
supplemental rebates will have their products included on the states’ list of preferred drugs. All 53
others are subject to prior authorization.
Medicaid’s federal upper payment (FUL) levels are calculated consistent with a statutory formula
and based on data submitted by pharmaceutical manufacturers. The FULs apply separately to
multiple source and to all “other” drugs and are applied in the aggregate to each state’s spending
for drugs. The FULs for multiple source drugs, defined to include any drug for which there is at
least one other drug sold and marketed during the period that is rated as therapeutically equivalent
and bioequivalent, are calculated by the CMS and are periodically published in the state Medicaid
Manual. For these multiple source drugs, the FUL, beginning January 1, 2007, is equal to 250%
of the “average manufacturer price” (AMP) for the product computed without regard to prompt
pay discounts. The AMP is a price reported to CMS by manufacturers, and is calculated to be the
average price at which manufacturers sell a drug product to wholesalers.
Each state must assure the Secretary that its Medicaid spending for multiple source drugs is in
accordance with the upper limits plus reasonable dispensing fees. The effect of the FUL
requirement is that, when a lower-cost “generic” equivalent exists for a brand-name drug, a state
can only claim federal matching share for a reimbursement level that is tied to the generic price
even if the brand-name drug is actually furnished. The state has incentives, therefore, to establish
policies to encourage the substitution of lower-cost generic equivalents for the brand-name
counterparts. The upper limit for multiple source drugs does not apply if a physician provides
handwritten certification on the prescription that a specific brand is medically necessary for a
particular recipient. The brand name would then be dispensed subject to the limits applicable to
“other” drugs.
All “other” drugs include brand-name drugs and multiple source drugs for which a specific FUL
limit has not been established. The upper limit that applies to “other” drugs is the lower of the
estimated acquisition cost (EAC) plus a reasonable dispensing fee or the provider’s (usually a
pharmacy’s) usual and customary charge to the general public. The EAC is the state Medicaid
agency’s best estimate of the price generally paid by pharmacies to acquire the drug. States may

53 For more detailed information on Medicaid drug coverage, states payment formulas and supplemental rebates, see
CRS Report RL30726, Prescription Drug Coverage Under Medicaid, by Jean Hearne.

use another payment method as long as, in the aggregate, a state’s payments for “other” drugs are
below the payment levels determined by applying the upper limit for “other” drugs.
Rebates are computed and paid by pharmaceutical manufacturers each quarter based on
utilization information supplied by the state programs. The formula for calculating Medicaid
rebates is different based on which of the two following groups the drug falls into. The first group
includes single source drugs (generally, those still under patent) and “innovator” multiple source
drugs (drugs originally marketed under a patent or original new drug application (NDA) but for
which generic competition now exists). Rebates for the drugs in the first group are equal to the
greater of 15.1% of the AMP and the difference between the AMP and the best price. Additional
rebates are required if the weighted average prices for all of a given manufacturer’s single source
and innovator multiple source drugs rise faster than inflation, as measured by the consumer price
index for all urban consumers.
The second class includes all other “non-innovator” multiple source drugs (generics). Rebates for
non-innovator multiple source drugs are equal to 11% of the AMP.
There is no federal Medicaid formulary, although states are able to establish formularies for their
Medicaid programs. However, federal rules impede states from establishing restrictive
formularies. First, federal rebate policies essentially ensure that all drugs sold by a manufacturer
are made available to Medicaid beneficiaries if the manufacturer participates in the rebate
program. In addition, states are required to cover any non-formulary drug (with the exception of
drugs in 10 specific categories) that is specifically requested and approved in advance through a
defined process (generally referred to as prior authorization). The 10 categories of drugs that
states are allowed to exclude from coverage include drugs used (a) to treat anorexia, weight loss
or weight gain; (b) to promote fertility; (c) for cosmetic purposes or hair growth; (d) for the relief
of coughs and colds; (e) for smoking cessation; and (f) prescription vitamins and mineral products
(except prenatal vitamins and fluoride preparations); (g) non-prescription drugs; (h) barbiturates;
(i) benzodiazepines; and (j) drugs requiring tests or monitoring that can only be provided by the 54
drug manufacturer.
In 2005, 25 state agencies report having established preferred drug lists for their Medicaid
programs. States use other mechanisms as well to discourage unnecessary drug spending.
Mandatory generic substitution, dispensing limits, prior authorization, and beneficiary co-
payments are all additional tools states report using to keep control of drug spending.

Depending on the policy outcome the Congress wishes to achieve by establishing the authority
for the Secretary to negotiate drug prices, there are a number of alternative ways to go about
doing so. Medicaid and the VA provide models for a few of these alternatives. If, for example,

54 By law, all of these categories (except for smoking cessation) are excluded from Medicare Part D coverage.

Congress’ primary objective is to lower the overall cost of the program, a set of ceiling prices
may be sufficient to achieve such an objective. If, on the other hand, the primary purpose of such
actions would be to lower overall costs, while minimizing the number of parties who are
negatively affected by policy, then mandated rebates could be appropriate. However, none of
those approaches directly impact the premiums drug plans might charge or co-payments that
beneficiaries face at the pharmacy; rather, indirect effects are possible. If Congress’ primary
objective is to impact those amounts, an explicit policy targeted at cost sharing or premiums
could ensure those objectives are met. The following section identifies a few alternative
approaches that Congress may consider.
One way in which lower drug prices might translate into lower overall costs is through a 55
Medicare ceiling price. Ceiling prices could be established to resemble Medicaid’s federal upper
limits, or the federal supply schedule prices. There are however, both administrative, and other
complications to establishing such a system. Without combining such a policy with a national
Medicare formulary—and the threat of excluding high priced drugs from such a formulary—
CMS may not be able to negotiate adequately favorable ceiling prices. Also, a ceiling price policy
does not necessarily translate into lower costs at the pharmacy counter for beneficiaries, nor does
it translate into lower purchasing prices for pharmacies. Other policies could be combined with
ceiling prices to ensure lower prices for beneficiaries or pharmacies.
Finally, ceiling prices that reduce reimbursements significantly could have indirect effects on
beneficiary access to future innovative drug products, and even economic impacts on other payers
and providers. For example, manufacturers may lose profits, which may adversely affect
pharmaceutical research and development, as well as increase costs for non-Medicare consumers.
Pharmaceutical manufacturers have argued that lower profits impede their ability to research and 56
develop new disease treatments. This argument has been both supported and refuted by many 57
academics. The manufacturers may also choose to recoup the lost profits by increasing the drug
prices for other consumers. Such a policy would need to be carefully crafted to minimize
unintended consequences.
Another way of lowering out-of-pocket payments for beneficiaries might be to mandate larger
rebates from manufacturers to Part D drug plans. This system could resemble Medicaid’s rebate
system. Larger rebates would lower Part D drug plans’ net costs of drugs for beneficiaries.
Assuming market competition works in the Part D Program, lower net costs could be passed onto
beneficiaries in the form of lower premiums, and perhaps also lower copayments. Alternatively,
manufacturers could provide these rebates directly to the CMS. If market competition does not

55 For more information on price ceilings, see CRS Report RL33781, Pharmaceutical Costs: An International
Comparison of Government Policies, by Gretchen A. Jacobson.
56 For more information, see Pharmaceutical Research and Manufacturers of America (PhRMA),What Goes Into the
Cost of Prescription Drugs? ... And Other Questions About Your Medicines. Available at
57 For examples of academic research on the subject, see John A. Vernon, “Examining The Link Between Price
Regulation and Pharmaceutical R&D Investment,” Health Economics, January 2005; 14(1): 1-16. See also Jerry Avorn,
Powerful Medicines: The Benefits, Risks, and Costs of Prescription Drugs (Knopf, New York, 2004).

fully work, Congress might need to require that Part D plans pass lower costs onto beneficiaries
through reduced premiums.
As previously discussed, lower Medicare profits for manufacturers may adversely affect
pharmaceutical research and development, and may also increase costs for non-Medicare
consumers. However, larger rebates may not adversely affect wholesalers or pharmacists.
A new Medicare pharmacy purchasing system would be another option that might help translate
lower manufacturer drug prices for Medicare Part D into lower out-of-pocket and overall costs for
beneficiaries. One example of such a system could resemble the VA’s mail-order pharmacy
system. The new Medicare pharmacy purchasing system could negotiate drug prices and purchase
drugs from manufacturers or wholesalers, and then distribute the drugs and receive payment from
This approach is potentially the most administratively burdensome of the options, since it would
require developing a Medicare pharmacy distribution system. Pharmacists may experience
increased administrative costs if they were to be required to track and purchase drugs separately
for their Medicare customers, since pharmacists rarely track drugs by payer under the current
system. Some of the burden could be alleviated through heavy use of a mail-order system.
If a mail-order system is established, pharmacists, and possibly wholesalers, could lose profits
because they would lose Medicare business. The Part D plans might have a considerably reduced
role in the new system. As with any price reduction, manufacturers’ profits from Medicare might
be reduced and they may choose to recoup lost profits by increasing drug prices to other
consumers. Finally, a complete mail-order system is not a realistic option because many
beneficiaries may prefer to talk to their pharmacist directly, and may not wish to participate in a
mail-order program.
Gretchen A. Jacobson Jean Hearne
Analyst in Health Care Financing Specialist in Health Care Financing, 7-1686, 7-7362
Sidath Viranga Panangala
Analyst in Veterans Policy, 7-0623