The Costcoization of Healthcare: Shunning Excessive Profits

 Costco is a large retailer with the worldwide reputation of providing low prices for quality goods.  You have to love a place where you can get inexpensive toilet paper plus a great bargain on Dom Perignon.  It operates with a different model than most retailors in that it charges an annual membership fee.  Wikipedia describes its cost philosophy.

“The company’s rule is that no regular item may be marked up more than 14% over cost, and no Kirkland Signature [home brand] item may be marked up more than 15% over cost.  The company runs very lean with overhead costs at about 10% of revenue and profit margins at 2%.  Membership fees…account for 80% of gross margin and 70% of its operating income.”

In other words, Costco’s business plan depends mostly on having growing numbers of satisfied customers willing to pay the $60 or $120 membership fee rather than extracting profits from the sale of merchandise.  Its customers seem to like this approach, saving lots of money on reliable bargains and receiving good service from well-paid workers.

Costco’s business model is effective, but in the retail world it is not revolutionary.  Where such a business model would be a game changer is in the healthcare field.  There the customers are captive and do not have to be satisfied in order to harvest their wealth, and each individual service is priced to produce a profit.  Costco has ventured into healthcare in the past by providing pharmaceuticals under its traditional low-cost policies and making the bargains available even to nonmembers.  A Bloomberg Businessweek article by John Tozzi, Costco Brings Its Low-Price Magic to Employer-Paid Drug Plans, indicates Costco is getting into the pharmacy benefit management game.

“The company best known for its cavernous warehouse stores, where it sells everything from TVs to pallets of paper towels, has become partners with Navitus Health Solutions LLC, a small pharmacy benefit manager based in Madison, Wis., on a strategy that could rewrite the complicated playbook for running prescription plans.”

Pharmacy benefit managers (PBMs) are hired to act as intermediaries between institutional healthcare providers and drug companies in order to negotiate lower drug prices and save the providers money.  These PBMs also have leverage over the drug companies by having control over the list of drugs that are considered “preferred medications.”  If a company’s product does not make that list, then it will lose sales revenue—perhaps a lot.  What the PBMs do is not negotiate the list price of a drug, but the discount price that a given provider will pay for the drug.  The PBMs take a percentage of the discount to the providers as their income and are paid a fee by the care providers.  People not in one of the provider’s plans will end up paying the full list price.  The insightful reader will have already become suspicious about this system.

Consider the perverse set of incentives operating in the negotiation between PBMs and drug companies.  If two companies have equivalent drugs and one is cheaper than the other, the PBM can make more money from dealing with the more expensive product.  The cheaper drug company recognizes this factor and concludes that it is in its best interest to raise the price of its drug to match or even exceed that of the competitor.  This type of competition can easily lead to competitors frequently raising prices in lockstep.

The PBM can use the higher price to provide greater discounts to the healthcare providers.  Consequently, the providers may not be too much bothered by this scam, but this is far from a victimless crime.  We end up with two prices for drugs: the inflated list prices and the negotiated discount prices.  The problem that arises is people without insurance being required to pay the artificially high list price.  People without medical coverage, the least likely to be able to pay, will face the list price.  People with a healthcare plan but with a high deductible will be required to pay the full list price until the deductible is met.  The Medicare system is not allowed to negotiate prices with drug companies so the taxpayers are getting gouged, as well as the elderly who use a lot of medications. 

Navitus, as a PBM, has adopted a business plan similar to that of Costco in which they accept no funds from the drug price negotiations and take only the fees received from its provider clients.  If the model works, healthcare providers, patients, and governments will save money, providing more clients for Navitus. 

“Pharmacy benefit managers, better known as PBMs, traditionally make money by pocketing a portion of the rebates and discounts they negotiate with drugmakers for employers. In contrast, Navitus offers a fee-based model that passes on all the savings it creates to its employer clients. After working with Navitus for years, Costco purchased a minority stake in the closely held company in 2020. Now executives from both companies say the investment will help accelerate their growth at a time when drug costs are increasingly burdening U.S. businesses and consumers. “We believe that the marketplace is really starting to place a value on our particular business model,” says Navitus Chief Executive Officer David Fields.” 

Navitus is now small compared to the major PBMs, but it has acquired a good track record, including managing Costco’s employee health plan with its 300,000 US members. 

“Navitus’s 100% pass-through model saved the retailer millions of dollars on drug costs, according to Costco Chief Financial Officer Richard Galanti, while aligning with a core Costco strategy. ‘We’ve always been known for passing on as much savings as possible directly to our member, to our customer, whether it’s food and sundries or prescriptions,’ he says.”

One way in which this marriage can help is by facilitating access to the low drug prices maintained at Costco pharmacies by more consumers.

“Navitus and Costco are exploring ways to wring further savings out of the prescription supply chain—and drive more business to the 538 pharmacies at U.S. Costco warehouse stores. The companies are testing a plan that makes Costco the preferred pharmacy for one client in California.”

Tozzi warns that the current system may be near a breaking point as mergers of players into more complex entities nearly eliminates any transparency it may have once had.

“In the past several years, PBMs have gotten bigger and more powerful. The three largest processed about 77% of U.S. prescriptions in 2020, according to industry publication Drug Channels. And they’ve been consolidated into larger health-care enterprises—UnitedHealth Group, CVS Health, and Cigna—and integrated with related businesses such as health insurance, medical care, and pharmacies.”

“The consolidation has left some employers looking for alternatives, says Elizabeth Mitchell, CEO of the Purchaser Business Group on Health, a coalition of large employers. ‘The bigger these entities get, and the more integrated, the harder it is in some cases to actually have meaningful accountability, she says. ‘You can’t tease apart where the waste is’.”