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Two-Tier Pricing: Unequal Protection

Two-Tier Pricing: Unequal ProtectionMany third-party prescription drug benefit programs use two-tier pricing schemes that differentiate between “chain” and “independent” pharmacies. In almost all situations, discounts off the Average Wholesale Price (AWP) of drugs are smaller for the independents and larger for the chains. For example, the independents may be reimbursed using a formula of AWP minus 10% (plus a “dispensing fee” minus any co-pay). The formula for a chain in the same program might be AWP minus 15%. The rationale given for the dichotomy is a belief that the chains have the ability to secure larger discounts from the wholesalers and manufacturers by virtue of volume purchases. Independents are viewed as not having the same leverage. There is, of course, a wide variation in the amount of the discounts and just what constitutes an “independent” or a “chain” pharmacy.

Wal-mart and Walgreen’s indicated they would withdraw as Medicaid providers if the higher discount rate imposed on chains went into effect.

As might be imagined, most of the independent pharmacy operators favor this pricing differential as a means of “leveling the playing field.” The chains, for the most part, view the differential as arbitrary and capricious, with little or no actual justification. Many chains assert that the belief that they have market power to demand greater discounts is largely based on anecdotal evidence that is not supported by any credible studies. From the chain perspective, differentiation creates a decidedly unequal playing field.

Up until recently, however, there has been little success in challenging these reimbursement methodologies. A new case may change that. If this case is not reversed during any appeals, pharmacy benefit programs, at least those supported by various government agencies, will have to modify existing payment plans to pharmacies.


The Arkansas Department of Human Services administers the Medicaid program for that state. On April 24, 2000, the Department adopted a plan that would reimburse independent pharmacies at the rate of AWP minus 10.5% plus a dispensing fee of $5.51. Chain pharmacies would receive the same dispensing fee but the cost of drugs would be reimbursed at AWP minus 17.3%. In separate lawsuits, consolidated for this decision, Wal-Mart and Walgreen’s sued the Department in federal court, claiming that the two-tier scheme violates both the federal Medicaid Act and the Equal Protection clause of the Fourteenth Amendment to the United States Constitution. Both chains sought a permanent injunction to stop implementation of the new program. The plaintiff-chains claimed that the defendant-Department considered factors that are not permitted under federal law when it adopted the plan and that, to the extent that chains are treated differently than independents by the Department, there is unconstitutional discrimination between similarly situated pharmacies without any rational reasoning.

It is noteworthy that 75% of all pharmacies in Arkansas are considered independent. Nevertheless, Wal-Mart operates 84 pharmacies and Walgreen’s has 13 pharmacies in the state. Both chains indicated to the Court that they would withdraw as Medicaid providers if the higher discount rate imposed on chains went into effect. This would mean an immediate 25% reduction in access to pharmacies providing services to Medicaid patients in that state.

Federal Medicaid Law

Medicaid programs are the joint efforts of the federal and each of the state governments. The federal law sets the standards for participating states to administer the benefits provided to indigent patients. Each state is reimbursed by the federal government for a percentage of the benefit paid by the state to providers. There is no mandate that any state provide any of the benefits available under federal law. However, if a state does elect to participate in the Medicaid program, it must follow federal guidelines regarding payment schedules, coverage and access. The Health Care Financing Administration (HCFA) oversees Medicaid at the federal level and adopts regulations designed to implement the various statutes constituting the Medicaid Act. While all state plans and modifications to plans for eligible benefits must be approved by HCFA, the plans are deemed to be approved 90 days after they are submitted unless HCFA objects. In other words, a plan might be deemed approved even if it is never reviewed at the federal level. Insofar as brand-name prescription drug benefits go, the federal program requires states to reimburse pharmacies at the less of either the usual and customary price or by the estimated acquisition cost (EAC). Almost all brand-name drugs are paid for at the EAC level. EAC is defined as the agency’s “best estimate of the price generally and currently paid by providers.” Each state has some flexibility to determine the EAC. However, the states are constrained in setting reimbursement rates by federal law that requires states to enlist enough providers so that services are as equally available to Medicaid recipients and the general public. This aspect of the law is generally referred to as the “equal access” provision. Providers who claim that reimbursement rates are too low in violation of the equal access provision often sue under the anti-discrimination provisions of the civil rights laws.


The district court judge hearing this case ruled that the Arkansas Medicaid program must consider certain statutorily mandated factors, including equal access, efficiency, economy and quality of care, when it sets pharmacy reimbursement rates. The judge found there was no evidence that the Department had followed this requirement. Instead, the Department only considered how other states determined pharmacy reimbursement rates. The Court found that this consideration was not relevant to how an individual state sets the rates.

The Court noted that the Department did contract with a private firm to survey pharmacy costs and reimbursement rates. That firm had conducted similar surveys in other states and made some of those data available to Arkansas. However, the survey was used primarily to determine the dispensing fee, not the EAC or the discount from AWP. The Department argued that the fairness of the reimbursement rate should be determined by considering both the dispensing fee and the AWP discount together. The Court rejected this position, noting that the federal regulation defines EAC as the best guess of providers’ actual costs. In other words, the dispensing fee amount and how that is determined is separate from the method of determining how to calculate a pharmacy’s actual drug costs.

In this case, the Arkansas department used the AWP discount to establish the EAC. The Department asserted that the chains regularly receive “secret” discounts of approximately 6.8% that are not available to the independents. However, no evidence was introduced to support this claim. In fact, the report generated by the firm hired by the Department to help set the fees concluded that, based on its surveys of the Arkansas pharmacies, there was no significant difference between the acquisition costs for chains and independents. That firm later recanted this conclusion but replaced it with a statement that the survey it conducted did not establish whether there is any difference between the prices paid for brand-name drugs between chain and independent pharmacies.

The Department also used surveys done in other states to determine the appropriate discount rate. The judge ruled that this consideration was completely wrong because the federal statutes dictate that each state consider the conditions that affect drug costs within that state.

The Court was also critical of the Department’s motives in establishing two-tier pricing. The judge observed that this was really a political and economic attempt to save approximately $4 million per year in Medicaid expenditures. The judge stated that it was his “clear impression” the 17.3% discount offered to the chains was really intended as a bargaining chip to induce the chains to come in and negotiate a more reasonable discount. This is wholly inappropriate, given the federal requirements that specific factors be used to objectively determine each pharmacy’s EAC for brand-name drugs.

The fact that the Department used different rates for independent and chain pharmacies and applied the formula across the board, without regard to the size or type of chain or to the kinds of services offered, was enough to convince the judge that the two-tier system was arbitrary and capricious and without a rational relationship to the federal mandates. Thus, reasoned the judge, there is no basis to differentiate reimbursement rates between chains and independents. Absent evidence that appropriate factors had been considered in determining the EAC, the Court ruled that the Department violated the Medicaid Act and engaged in unconstitutional discrimination.


Assuming this case is not overturned if or when it is appealed, its implications are significant to the interests of all pharmacies participating in any third-party program that incorporates differential reimbursement plans. Because this case involves Medicaid payments, by its nature, the decision would apply initially to publicly funded plans. However, because most private plans are highly regulated, it is very possible that other state agencies would adopt the rationale of this case to apply to private insurance or managed care plans as well.

While this might seem like good news, at least to the chain operators, a word of caution is offered to the independents and the rest of the pharmacy world. The evidence in this case suggested to the judge that all pharmacies in Arkansas should be reimbursed at the rate of AWP minus 10.5%. The judge could have concluded that all pharmacies should be compensated at the rate of AWP minus 17.3%. This would have accomplished the same goal of “leveling the playing field” sought by the chains because all pharmacies would be treated equally (perhaps, equally bad, but equally nonetheless). In fact, the survey evidence showed that the average pharmacy in that state, without distinction in type, only paid 82.7% of the AWP. Luckily for both the chains and the independents, the judge discounted the credibility of this survey. While there was no evidence supporting the idea that the 10.5% discount is any more accurate or any less arbitrary, at the very least it is more palatable.

One of the factors the judge expressed repeated concern over is whether or not pharmacies will remain in the provider network to assure that Medicaid recipients will have access to prescription drugs. The chains made a fairly clear threat to not participate at the 17.3% rate. If they followed through with this threat, the state would have lost 25% of its Medicaid pharmacies. While there might not have been evidence to support the 10.5% discount as any more reasonable, at the very least no one was threatening to pull out of Medicaid. That is, of course, good news for Medicaid-eligible recipients as well as the pharmacies that serve this needy population. Just beware that the next case could result in a verdict that is less pharmacy-friendly.

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