Because medication costs comprise the majority of health-system pharmacy budgets and continue to increase faster than other health care expenditures,1 drug costs are a constant target for cost containment initiatives. The purpose of these guidelines is to provide guidance on medication-cost-management strategies.
These guidelines recommend techniques to manage drug costs in hospitals and health systems. The guidelines focus on drug use in inpatient settings and hospital clinics, where health-system pharmacies typically have responsibility for purchasing and distributing drugs. Strategies for other settings, such as managed care and ambulatory care settings, and strategies for revenue optimization are beyond the scope of this document. Although revenue optimization and medication cost management are complementary approaches to improving the financial performance of pharmacy departments, revenue optimization is best addressed through literature specific to that topic2,3 and is not extensively reviewed in this document.
These guidelines examine methods for nonlabor pharmaceutical cost containment, focusing primarily on variable costs (costs dependent on patient volume) and direct drug costs. Fixed and indirect costs, such as labor to prepare or administer medication, nonpharmaceutical materials, and overhead, are also beyond the scope of these guidelines. There is also not an attempt to consider the impact of drug costs and drug-cost-management strategies on other hospital departments (e.g., laboratory, respiratory care) or on the total health care costs once the patient leaves the acute care setting. Although not discussed here, these shifts in drug costs are important to consider as drug therapies influence other health care costs, and pharmacists should lead efforts to promote the value medications provide across the hospital and health care system.
A broad range of drug-cost-management strategies exist throughout hospitals and health systems. Some approaches are relatively straightforward and can be implemented within the pharmacy. Other approaches are more complex and require high-level strategic planning and extensive collaboration throughout the hospital. Successful drug cost management requires systematic attention to and integration of both approaches. Because of the different nature of various drug-cost-management activities, these guidelines present information at different levels of complexity appropriate to the approach being described.
When selecting and implementing drug-cost-management strategies, it is essential that pharmacists remain mindful of patient safety and the quality of patient care.
Drug-cost-containment initiatives must never compromise the department’s ability to provide the best possible care to patients. In many cases, it is prudent and necessary to monitor and evaluate the safety and outcomes of drug-cost-management projects. Fortunately, many drug-cost-containment strategies have little or no potential for detrimental effects on patient care, and efforts to improve the quality of drug use often coincide with cost-containment initiatives.
Trends in Medication Expenditures
Senior hospital administrators have recognized the importance of drug costs to the fiscal status of health systems. For example, a health care consultancy reported that in 1996, “managing hospital drug utilization and expenditures” was not ranked in the top 20 concerns for hospital CEOs.4 When the survey was repeated in 2000; however, hospital CEOs ranked drug costs as their seventh most important concern. The 2000 survey also reported that among hospitals’ greatest financial challenges, drug and technology costs were second only to decreased reimbursement, and hospital CEOs said that drugs offered the single greatest opportunity for cost savings.4 Although somewhat dated, these data illustrate that drug-expenditure management presents health systems with an important challenge that is recognized by senior hospital administration.
Four primary factors drive growth in overall drug expenditures: price, utilization, mix, and innovation.1
Price inflation is an increase in the unit price of existing medications. Utilization is an increase in use of a drug, such as an increase in number of users, days of therapy, or dose per day of therapy. Mix changes when newer, more expensive therapies are used in place of older, less expensive but equally effective drugs. Finally, a blend of the utilization and mix factors increases drug expenditures when expensive, new medications become available to treat conditions previously untreatable with drug therapy (i.e., innovative therapy).
The United States spent over $250 billion dollars on prescription drugs in 2005, but total drug costs represent a relatively small portion of total U.S. health care spending (approximately 11%).5 However, double-digit increases in prescription drug expenditures have been common (e.g., 15% in 2000, 18% in 2001, 12% in 2002, 11% in 2003, and 9% in 2004).1,4,6 The rate of drug-expenditure growth has frequently been higher than inflation, increases in wages, and other health care spending, including spending for hospitals, physician services, and total health care expenditures. However, with the exception of 26% growth in 2001, the recent rate of growth in hospital drug expenditures has been less than the growth of total drug expenditures. Hospital drug expenditures grew 4.9% in 2000, 26% in 2001, 9.7% in 2002, 6.3% in 2003, 7.9% in 2004, and 5.7% in 2005.1,5–7 However, the rate of growth in clinic drug expenditures has consistently exceeded the growth of total drug expenditures. Clinic drug expenditures grew 24.6% in 2000, 23% in 2001, 21.3% in 2002, 22.2% in 2003, 13.5% in 2004, and 12.4% in 2005.1,5,7
While the rate of increase in prescription drug expenditures moderated somewhat between 2004 and 2006, drug-expenditure growth remains substantial. Long-range forecasts suggest that the rate of increase in total prescription drug expenditures will continue to exceed the rate of increase for total health care expenditures through 2014. Because drug expenditures are the largest component of every health-system pharmacy’s operating budget and often a meaningful portion of the entire hospital operating budget, drug expenses attract significant attention from hospital leaders. For these reasons, it is apparent that drug-expenditure-management will remain an area of focus and responsibility for health-system pharmacists for the foreseeable future.8
A systematic approach to planning and prioritizing specific drug cost management strategies is essential when implementing initiatives that will influence drug expenditures in a health system. Annual financial planning (i.e., budgeting) is the most common planning approach, and specific drug-cost-management strategies should be considered a part of the budgeting process. However, longer-term strategic and programmatic planning activities also have an important role in managing drug expenditures.
A systematic approach to drug-cost containment requires specific and detailed data on both health-system drug purchases and actual drug-use patterns. Data must underlie all types of planning to manage medication expenditures. Systems should be established to have ready access to the data and continually review and monitor these data.
It is essential to interact and collaborate consistently with physician leaders from various specialties to successfully plan, prioritize, and implement medication-cost management efforts. Physician involvement must be sought during the annual financial planning process and when doing strategic or programmatic planning related to drug expenditures. Appropriate physician representatives must also be engaged in specific drug-cost-management initiatives. During the annual financial planning process, physicians can provide important information related to drug costs, such as anticipated use of key drugs in the pipeline, programmatic or new service implementation, anticipated recruitment of specialists who may require high-cost agents, projections for use of high-priority drugs, and insights for drug cost containment. Pharmacy leaders can also use this opportunity to update physicians on the pharmacy department’s recent accomplishments and goals for the future.
Drug Budgeting. Although a complete discussion of the drug-budgeting process is beyond the scope of this document, several important suggestions are provided below. A general approach to systematically developing the annual drug budget is outlined in Table 1.7 At the beginning of each calendar year, the American Journal of Health-System Pharmacy publishes a projection of drug expenditures for that year.1,5–7
Steps for Developing Annual Drug Budget7
Collect and review data (e.g., drug purchase data, drug utilization data, workload and productivity data, other financial statements).
Develop budget for high-priority agents (top 50–60 drugs).
Identify relevant new drugs and build new agent budget.
Budget for nonformulary drugs and lower-priority drugs.
Establish a drug cost containment plan (identify drugs going off patent, opportunities for therapeutic interchange or protocol development).
Finalize and present the total drug budget.
Continue the budgeting process throughout the year through constant vigilance and monitoring of drug use.
Annual drug budgeting is a challenging exercise. Unanticipated situations that result in extreme increases in drug expenditures will likely occur and the pharmacy director should be prepared to explain those situations. Better data and more experience will improve a department’s ability to forecast institutional drug expenditures. Regardless of the drug budget’s accuracy in forecasting the institution’s drug expenditures, a well-planned drug budget should help the department understand drug use patterns and identify opportunities for drug cost management. Specific reports that can be helpful in understanding drug use will be described below.
During the annual financial planning process, it is important to identify and focus on key drug expenditures. The Pareto Principle, or 80/20 rule, applies to drug budgeting and states that in nearly all cases, a few vital factors are important and many are trivial. A relatively small number of drugs (50–60) typically account for 80% of most hospital drug budgets. Therefore, budgeting and cost-containment efforts should focus on those drugs, and the cost-management plan should especially concentrate on those top drugs for which it is feasible to influence prescribing patterns. Much of this document focuses on the need to develop a cost-containment plan after initial estimates of drug costs are completed (Table 1).
Medication-cost-management projects should be carefully selected and prioritized as part of an ongoing financial planning process. Because drug-cost containment strategies must be customized to each health system’s unique characteristics, a global assessment of the pharmacy department and the hospital must be conducted to identify opportunities for drug-cost-management. This assessment must go beyond a qualitative assessment of opportunities and must include retrieval and analysis of both drug purchase and drug-utilization data. Pharmacy departments may need to obtain and develop resources, such as personnel and software, to analyze these data.
Despite the need to customize the strategy and tactics to fit the needs of different hospitals and health systems, a systematic approach to identifying, prioritizing, and implementing medication-cost containment initiatives is necessary and can be applied in any setting. A clearly defined list of cost-containment targets should be established during each financial planning cycle. To be successful, the number of initiatives should be manageable and should focus on the institution’s top expenditures. In many situations, multiple approaches for cost containment will be necessary.
The foundation for effective cost-management strategies, and the first stage of the systematic approach, begins with determining current costs of medications, both as ongoing expenses and those held as assets in inventory. Understanding and tracking key medication-cost indicators on an ongoing basis is necessary to determine the opportunities for medication-cost reduction. Examples of these indicators may include:
- Medication inventory per adjusted patient day
- Medication inventory turnover rate
- Contract coverage percentage
- Contract compliance percentage
- Intravenous-to-oral dosage ratio
- Volume-adjusted total medication costs (e.g., cost per adjusted patient day, discharge, etc.)
- Volume-adjusted drug category costs (e.g., antibiotics, anesthesia-related drugs, etc.)
- Descending-order total purchase histories, tracked over time
In addition, the use of external benchmarks may provide assistance in identifying medication-cost-reduction opportunities. External benchmarks may be available as a component of services provided by consulting organizations, the pharmacy’s drug wholesaler or group-purchasing organization (GPO), or from professional published data. Benchmark data should be used with care; however, because there may be important limitations to the applicability of the data to a specific site. For example, difficulties may exist in adjusting the data for the specific pharmacy practice, such as models and intensity of services, and in finding an appropriate peer group.9
After cost-management opportunities are identified, they need to be quantified. Dollar values should be assigned to each opportunity, including inventory reduction, improvement in inventory turns, improving contract compliance, therapeutic interchange of various agents, and others. A specific goal and action plan should be set for each drug-cost-management target. For example, one goal might be to reduce expenditures for a drug class by 8% by establishing a contract for a new, preferred agent and implementing a therapeutic interchange program to shift use to the new agent. Alternatively, the goal might be to slow the rate of increase in use of a particular drug or drug class (e.g., based on current patterns, use of this drug class is expected to grow 15% in the next fiscal year, but the goal of interventions is to limit the rate of increase to 10%). Monitoring is essential, so drug cost containment targets should be consistently measured and evaluated. Identifying and quantifying the opportunities must be completed before prioritization and in-depth evaluation begins.
Assessment and Prioritization. Once opportunities for cost management have been identified and quantified, assessment and prioritization can occur. There are many methods of prioritization, but most of them contain two key elements: determining the potential benefit and estimating the relative ease or difficulty of attaining the benefit. Even though potential benefit may be clear-cut, the degree of difficulty is often hard to establish. Important points to consider when determining the relative degree of difficulty and likelihood of achieving benefits from a given drug-cost-management opportunity include (1) the amount of time pressure (the time available until the cost reductions occur), (2) key stakeholder (e.g., nurse, physician) sensitivity and willingness to collaborate, (3) extent of leadership support for the initiative, (4) resources required, and (5) existing level of expertise within the organization for the specific cost-management opportunity.
Drug-cost management strategies that are under the direct and exclusive purview of the pharmacy department (e.g., purchasing, inventory management, and waste reduction approaches) are generally easier to implement and provide more immediate benefits. These activities, however, often provide smaller or one-time financial benefits. Utilization management tactics (e.g., clinical practice guidelines and therapeutic interchange) generally provide greater financial benefits, but these efforts have correspondingly higher degrees of difficulty and complexity.
Because of the relative ease of implementation, cost-containment opportunities in areas that are primarily under the department’s control will usually be pursued first. After these initiatives are underway, more complex techniques that require collaboration with the medical staff and others should be pursued.
These guidelines are structured so that the cost-management techniques are presented in the order in which health systems often implement them. Components of a cost-management program are listed in Table 2. An appendix that lists specific cost management opportunities is also provided. It is important to note that although these guidelines are separated into sections on purchasing and inventory management and medication-use management, both activities are integral and indivisible to drug-cost management planning and the practice of pharmacy in hospitals and health systems.
Components of a Cost-Management Programa
I.V. product waste
Medication utilization program
Clinical pharmacy services
Assessment of drug costs
Medical staff support
Plan implementation and
Reimbursement & Charging
CMS (DRG class)
Commercial insurance (payer
Outpatient infusion center
Coding and processing
Indigent care programs
aGPO = group purchasing organization, CMS = Centers for Medicare and Medicaid Services, DRG = diagnosis-related group.
Purchasing and Inventory Management
When selecting drug-cost-containment initiatives, purchasing and inventory management procedures should be considered first.
Drug Product Costs and Procurement. At the most fundamental level, drug costs are a function of unit costs and utilization. Drug-unit costs are a function of acquisition costs (contracted or non-contracted), the external (in-bound) distribution fee, inventory management costs, and internal distribution costs.
Contracting. There are three main avenues for purchasing pharmaceuticals at discounted rates: GPO contracts, facility contracts, and wholesaler own-use contracts. All facilities should seek to maximize savings available from use of generic products, and some may have other considerations, such as use of 340B or indigent care programs.
GPO contracts. GPOs utilize the aggregate purchasing power of many facilities in negotiating pricing agreements with manufacturers. Most hospitals are members of a GPO. While there are GPOs that focus exclusively on drugs, the majority of GPOs offer contracts for medical and surgical supplies, food, and other support products and services in addition to pharmaceuticals. Most GPOs make their contract portfolio available to members via hard copy, and some GPOs have contract portfolios available on secure internet sites. Considerations in contracting with a GPO are listed in Table 3. It is also important to have routine surveillance, preferably an automated service, that ensures that contract prices are applied to all purchases.
Considerations in Group Purchasing Organization (GPO) Contracting
Fees (e.g., contract administrative fee)
Allowable distribution methods
Supplier performance requirements
GPO services (e.g., lost savings and compliance reports, rebate and contract administration fee reports, clinical utilization management programs)
Letters of commitment
GPOs are funded by one of two means. First, most, if not all, GPOs collect a contract administrative fee (CAF) from the manufacturers or distributors with which they contract. The CAF is rarely greater than 3% of the dollar volume of product purchased through the contract. Some GPOs return a portion or all of the CAF to its members. If any or all of the CAF for a particular drug product is returned to the facility by the GPO, it should be taken into account when calculating the net cost of the drug. The second method by which GPOs are funded is direct payment of fees by members to the GPO. In this arrangement, all of the CAF is returned to the facility.
Contracts through GPOs consider not only the unit cost of the pharmaceutical but also include the allowable distribution methods for the pharmaceutical, payment terms, returns policies, and supplier performance requirements. Many GPO contracts, especially those for multi-source generics, include simple line-item pricing, which only requires the purchaser to buy and pay for the product. Other contracts are more complicated, with incentive rebates for all purchases or rebates for achieving volume or market share targets.
Typically, market share agreements are utilized when two or more products can be used to treat the same disease and no generic equivalent exists. The incentive, such as a rebate, a lock-in of a current discount, or achievement of a higher discount, is contingent upon attaining a given market share for a particular product in the institution’s market basket. To achieve the greatest financial advantage from the contract (lowest net drug cost), the pharmacy must work with the medical staff. This process requires a careful evaluation of comparative efficacy and safety of the product and its alternatives.
Some GPOs have multiple products on contract within categories of pharmaceuticals, allowing the facility to receive discounted pricing on similar agents when prescribing practices are not standardized to one agent. More aggressive GPOs will sometimes contract for a single agent within a particular class (e.g., for one fluoroquinolone or one liposomal amphotericin B product to the exclusion of others) in order to gain the maximum value for its members.
Successful use of GPO contracts requires a constructive and collaborative relationship between the member, the GPO, the manufacturer, and the distributor (i.e., wholesaler). Potential advantages of GPO contracts are listed in Table 4.
Potential Advantages of Group Purchasing Organization Contracts10,11
Standardization of products
Reduction of contract labor costs for institutions
Enhancement of member institution’s purchasing program
Enhancement of information sharing
Enhancement of purchasing expertise
Protracted periods of price protection
Coordination of contracting and budgeting process
Reduction of duplication of purchasing efforts among institutions
Assistance identifying alternative or secondary products during drug shortage
In addition to the contracting portfolio, GPOs offer services such as lost savings and compliance reports, rebate and contract administrative fee reports, clinical utilization management programs, and letters of commitment.
Lost savings and compliance reports. These reports provide data and analysis of missed savings opportunities in the user’s purchase history (e.g., items purchased off-contract when a generically equivalent alternative item was on-contract). These reports may also indicate the compliance level, or the amount of purchases on-contract versus the amount of purchases that could have been made on-contract (drugs purchased on-contract plus the value of drugs purchased off-contract when alternatives were on-contract). These reports should be reviewed monthly to determine if purchasing practices are effective.
Rebate and contract administration fee report. These reports tally the amount of rebates and contract administration fees generated by the facility’s purchases of specific products under contact. When evaluating the costs of two or more equivalent products, it is important to include any applicable rebates to arrive at net cost.
Clinical utilization management programs. These programs assist facilities in managing the utilization of various drug products and classes, often through evaluation and comparison of product efficacy, safety, and cost, as well as therapeutic interchange programs.
Letters of commitment. Letters of commitment (LOC) available through GPOs should be evaluated and taken advantage of when appropriate. The LOCs usually contain requirements for the pharmacy to do one or more of the following in order to gain lower pricing or rebates:
- Declare that a particular drug is on formulary.
- Declare that a particular drug will be on formulary and will not be restricted.
- Achieve a target periodic volume.
- Achieve a target market share relative to competitive drugs for a given period of time.
The LOC may not require significantly more purchasing of the drug. If LOC requirements do not conflict with formulary and utilization management strategies, the LOC should be signed if there is a reasonable chance of meeting the requirements.
Facility contracts. The alternative to GPO contracting is individual contracting. This type of contracting may be done at the facility or the health-system level. In some cases, equal or better pricing than GPOs can be obtained by individual facilities when contracting, especially large facilities or integrated delivery networks (IDNs). Opportunities for better pricing through individual contracting may exist for specialized health systems (e.g., those focused on oncology or transplantation), that purchase a large volume of a selected drug and are able to commit to maintaining a market share for the drug.
It is important to carefully evaluate the benefits of individual contracting and its influence on the collective bargaining power of the GPO. Continual use of individual contracts that are in contravention to GPO contracts, in theory, will eventually erode the GPO’s ability to consistently contract aggressively for its members. Because of larger GPO volume, manufacturers often will not offer the same pricing or other terms to individual facilities or IDNs that they offer to GPOs. Another factor to consider with individual contracting is that a facility may require contracts to be reviewed by attorneys, whereas the GPO acts as the contracting agent of the facility, obviating the need for legal review of each contract by the facility’s counsel. Finally, the amount of time required to negotiate, write, and maintain an individual contract should be weighed against the incremental value gained over what a GPO contract would offer. In many situations, it may be more efficient and productive to voice contract concerns to GPO representatives and become involved in GPO committees rather than write multiple, individual contracts outside the GPO.
Some drug contracts, especially for sole-source awards to generic manufacturers, call for the manufacturer to reimburse the pharmacy for the difference in cost when the pharmacy must purchase a product off-contract because the manufacturer was not able to supply the contracted product. The manufacturer-unable-to-supply reimbursement process is time-consuming and the requirements can be rigid, but submitting reimbursement to manufacturers under these provisions can return additional funds to the pharmacy.
Wholesaler own-use contracts. Wholesalers are also able to take advantage of special pricing on certain branded and generic drugs and offer those products to their customers in the wholesaler’s proprietary contract portfolio. This creates margin for the wholesalers that can be used to fund distribution discounts. Wholesalers also take advantage of cash discounts and quick-payment terms from manufacturers to increase their margin and to offer discounts to customers.
Generic Drug Savings Maximization. The expiration of patents on widely used branded drugs can result in large reductions in drug expenditures. It is important to be mindful of the opportunities presented by the first-time introduction of generics on high-spend branded drugs, both in budgeting and implementing rapid and effective uptake of generics when they are introduced.
Budgeting. There are several sources for monitoring patent expiration dates (off-patent dates) for branded drugs, including www.drugpatentwatch.com and the GPO. The GPO may also be able to estimate the potential initial savings from contracting for generic drugs that are first-time introductions. It is also important to determine when the first-time generic product will be available from multiple manufacturers. The initial savings differential between the branded and generic versions may be small because a single generic manufacturer often has a period of exclusivity before the generic drug becomes available from multiple sources. In some cases the savings may be so insignificant that health systems will choose to remain with the branded drug for safety reasons and consistency in product supply. Changing products several times within a short period of time could confuse caregivers, so pharmacy managers should weigh the benefits and risks of making such changes.