The Hidden Cost of a Poorly Structured Formulary

The Hidden Cost of a Poorly Structured Formulary: What Employers Are Actually Paying For

Pharmacy benefits are one of the largest and fastest-growing cost drivers in employer health plans. Yet they are also one of the least scrutinized. Most companies renew their PBM contracts without a detailed review, accept the formulary they are given, and hope the utilization management tools are doing something useful in the background.

The reality is more complicated. And the financial consequences of a poorly structured formulary are much larger than most employers realize.

What a Formulary Is and Why the Structure Matters

A formulary is the list of covered drugs in a health plan, organized by tier to determine what members pay at the pharmacy counter. Tier 1 drugs are typically generics with low or no copays. Tier 2 includes preferred brand medications with moderate cost sharing. Tier 3 and higher tiers cover non-preferred brands and specialty drugs, often with significantly higher out-of-pocket costs.

The structure of a formulary determines both what employees pay and what the plan pays. It also shapes prescribing behavior, though most employers do not think about it in those terms. When a brand drug sits on Tier 2 next to a therapeutically equivalent generic, the formulary is not doing its job. Members default to what they know. The plan absorbs the cost difference.

Good formulary design makes the financially preferable option the path of least resistance for members and their physicians.

Where Most Employer Plans Are Leaving Money Behind

In reviewing pharmacy benefit structures across different employer groups, a few patterns show up repeatedly:

• Brand drugs placed in lower tiers than their generic or biosimilar equivalents, often as a result of manufacturer rebate arrangements that benefit the PBM more than the employer

• Step therapy protocols that are inconsistently applied or waived too easily, allowing direct access to higher-cost drugs when lower-cost alternatives would be clinically appropriate

• Specialty drug management that relies entirely on the PBM's own specialty pharmacy rather than exploring open network options or third-party carve-out programs

• No clinical criteria attached to certain high-cost drug categories, meaning prior authorization is either not required or is approved as a matter of routine

Each of these gaps represents real spend. In some cases it is incremental. In others, particularly in the specialty drug category, it can be substantial.

The Rebate Misalignment Problem

One issue that deserves specific attention is the relationship between PBM rebates and formulary placement. PBMs negotiate rebates from drug manufacturers in exchange for favorable formulary positioning. The question employers should be asking is how much of that rebate flows back to them versus how much is retained by the PBM.

Traditional PBM contracts often allow the PBM to retain a portion of rebates as compensation. In some arrangements, the rebate retention is significant enough that the PBM has a financial incentive to keep higher-cost brand drugs on the formulary rather than replacing them with lower-cost alternatives.

This is not inherently illegal or even unusual. But it is a misalignment of interests that employers need to understand before they can evaluate whether their formulary is actually designed with their cost goals in mind.

What Transparent Contracting Looks Like

A growing number of employers are moving toward pass-through or transparent PBM models, where all rebates are passed back to the plan sponsor and the PBM is compensated through a flat administrative fee rather than spread pricing and rebate retention.

This model provides several advantages. The employer can see exactly what drugs cost, what the rebates are, and what margin the PBM is making. Formulary decisions can be made purely on clinical and cost grounds rather than being influenced by the PBM's economics.

The tradeoff is that transparent models often require more administrative engagement from the employer or their consultant. The plan does not run on autopilot. But for employers with pharmacy spend above a certain threshold, the visibility and control tend to be worth it.

How to Tell if Your Formulary Needs a Review

You do not need to be a pharmacy expert to identify the early warning signs that your pharmacy benefit structure deserves a closer look. Some questions worth asking:

• When did your organization last conduct a formulary audit or request a detailed drug spend report from your PBM?

• Do you know your effective rebate rate and how much of the gross rebate is being retained by the PBM?

• What percentage of your specialty spend is going through your PBM's in-house specialty pharmacy?

• Have there been any unusual spikes in specific drug categories over the past 12 to 24 months?

If any of these questions are difficult to answer, that itself is information. A well-structured pharmacy benefit should come with clear reporting and transparent economics.

If you are a benefits manager or employer looking for a second opinion on your current pharmacy benefit structure, I am available for consultations.

By Michael Lee, PharmD

Michael Lee, PharmD, is an independent pharmacy benefits consultant with a managed care background. He provides strategic guidance to optimize pharmacy benefit design and clinical care delivery, with expertise in formulary development, medical policy review, biosimilar strategy, Generic utilization, rebate optimization, and vendor-neutral PBM procurement.