Institute for the Study of
Healthcare Organizations & Transactions


This paper, which was presented at the annual meeting of the Association for Health Services Research in June, 1996, provides background information regarding mergers in the managed care sector of the prescription drug industry.  We will be adding material in the Fall, 2000 that will provide the current status of many of the firms.



A Turbulent Environment     Managed Care and Managed Pharmacy      The Emergence of PBMs

              Mail Order Pharmacies         Mergers


       PBMs        Vertical Mergers





The purpose of this paper is to present early data from an ongoing study of prescription benefit management (PBM) companies. The changes that occurred in the environment are discussed in order to provide a context for the evolution of managed care pharmacy and the emergence of PBMs. Descriptive data for the PBMs from 1994 is then introduced in order to establish a baseline for the analysis that will continue. The paper then identifies mergers that have occurred in the industry and the issues that will be important for analyzing both the mergers that have already occurred and mergers that may occur in the future.


The study sample consists of 34 PBM firms and represents national data obtained through a survey conducted in 1994 by the trade publication, Business Insurance. It includes information on 8 of the 10 largest PBMs in the country ("Doubts Emerge", 1995) as well as on relatively small firms.


A Turbulent Environment. Historically, pharmaceutical companies operated in a relatively stable and certain environment that was characterized by solid profits, little (if any) pressure to alter pricing policies, and large barriers to entry (McGahan, 1994). Much of the competition was blunted by several important factors. First, the drug manufacturers engaged in product differentiation. The market was de facto divided by the therapeutic class of drug and little product overlap occurred across the manufacturers. Second, there was little price pressure from buyers. Physicians, who purchased pharmaceuticals, were generally unaware of the prices of the drugs that they prescribed. Moreover, since insurers and employers began offering benefit packages that covered prescription drugs, individuals generally did not shop for the lowest priced drug. And even when out-of-pocket payments were built into the coverage, most individuals did not seek other sources for their prescriptions, other than a local pharmacy.

Finally, McGahan (1994) discusses three important barriers to entry that contributed to the lack of competition in the pharmaceutical industry. For the most part, the drug manufacturers maintained a large sales force which, together with expensive marketing campaigns, acted as a deterrent for new companies who wanted to enter the market. Other barriers included patent protected drugs and research and development programs that required a significant amount of time and money in order to bring new drugs into a market.

In the late 1980s and early 1990s changes occurred in the industry that, while not directly eroding individual company profits, nevertheless altered the nature of the environment in which the pharmaceutical companies operated. The Waxman-Hatch Act of 1984 simplified the requirements for the approval of generic drugs by the Federal Drug Administration (FDA). However, the impact of this legislation on the generic drug market was mediated by two factors. First, the use of brand name drugs was a taken-for-granted practice among physicians and pharmacists and therefore, initially, the substitution of generic drugs for them did not occur with great frequency. Second, McGahan (1994) suggests that some physicians may have feared legal liability if they altered their prescribing practices. They may not have completely trusted generic drugs and may have feared that if an adverse medical consequence occurred as a result of medication, then they might be held liable for not prescribing a standard brand name drug. For these reasons, many physicians did not embrace generic substitutes.

Although the implementation of the Waxman-Hatch Act did not by itself erode profits in the industry, its effect was to reduce the amount of research and development that was required before companies could enter the generic drug market. Therefore, in the generic drug producing segment of the industry, the barriers to entry were lowered.

A second broad environmental change occurred in 1989 when several generic drug manufacturers were accused of inaccurately reporting the results of laboratory tests and of bribing FDA officials in order to obtain approval of their generic products. And, while these incidents did not directly affect the profitability of the drug industry, they probably slowed the speed at which generic drugs were accepted by prescribing physicians.

A third broad environmental change involved the pricing impact of generic drugs on the rest of the market. As generic drugs entered the market, they were generally priced below the brand name drugs but usually not at the level of marginal costs (McGahan, 1994). As the volume of sales declined for the manufacturers of brand name drugs, they attempted to offset the decline by increasing prices to their base of remaining customers. Therefore, although this change affected the pricing structure of generic and brand name drugs in their respective categories, there was only a small net change in the average price of all drugs.

These broad environmental changes alone did not necessarily affect the profitability of the drug industry. However, during the late 1980s and early 1990s, three factors did begin to erode the profitability of the drug industry (McGahan, 1994): the growth of managed care and managed pharmacy benefits; the emergence of firms that administered benefit programs for employers (PBMs are one example); and the development of mail order pharmacies.


Managed Care and Managed Pharmacy. Managed care in the drug industry has generally focused on monitoring the utilization of prescription drugs. Managed care firms established information systems that were designed to track the prescribing patterns of physicians and pharmacists and the actual utilization of prescription drugs by patients. In addition, restrictive formularies were designed that had the effect of raising the awareness of physicians and pharmacists about the actual cost of drugs.

In 1994, IMS International, Inc. reported the results of a survey conducted during the years 1990-1993 of 979 employers who had fewer than 1000 employees. In 1990, 39% of the dollars paid by these employers for pharmaceuticals were paid exclusively by a managed care plan. By 1993, the share had risen to 53%. In addition, the percent of prescriptions covered by managed care plans was 37% in 1990. By 1993, it had risen to 50% (Business & Health Special Report, 1995).

In 1994, IMS International, Inc. reported the results of a study that examined the concentration of managed pharmacy benefits in eight states. The automakers' reliance on managed pharmacy benefits pushed Michigan to the top of list of states with the highest concentration of managed prescription drug benefits (Business & Health Special Report, 1995). For example, in Michigan, 70% of the total number of prescriptions were offered through a managed care plan. The average across all states was 50%.


The Emergence of PBMs. PBMs, as a separate organizational structure, emerged in the late 1980s and early 1990s and represent one form of managed care in the drug industry. They specialize in managing prescription benefits for employers and for other managed care organizations (MCOs) by utilizing mechanisms that verify subscriber/employee eligibility for benefits, process the claims, and manage communications with retail pharmacists (McGahan, 1994).

Since PBMs are recent developments and little is known about them, describing their basic characteristics is essential to understanding their role in the managed care environment. PBMs are based in every geographic region, with the highest concentration (47%) located in the central region of the country. However, PBMs tend to serve a national market through a network of pharmacies. In 1994, the mean number of pharmacies in direct contract networks was 32,000.

Of the 29 PBMs reporting ownership status (parent vs. no parent), 3 were owned by drug manufacturers, 7 by either some form of managed care or insurance company; 4 by either chain or retail pharmacies; 12 by various types of enterprises; and, 3 were independent.

The average firm was approximately 10 years old, however, 3 PBMs began doing business in 1994. The size of the firms, measured by the number of plan lives (both eligible and active) covered by the firms, ranged from 110,000 lives to 56,000,000. The median number of lives covered by the firms in the sample was 3,350,000. In general, the larger firms tended to be older firms (p < .03).

Nine core services were identified but only 25 firms (74%) offered all of them. Those services include: claims processing, prescription education for users and physicians, concurrent and retrospective utilization review, formulary review/management, monitoring of physician prescribing patterns, mail order drug plans, assistance with retail pharmacy networks, and consulting services regarding the design of pharmacy benefit plans.

Three core information reporting mechanisms were offered by 30 firms (88%) and included: prescribing patterns/physician profiling, generic vs. brand utilization, and patient/employee utilization reports. Finally, the firms offered a mix of reimbursement methods to employer clients: 88% offered fee/claim; 79% volume discounts; 65% negotiated rates; and, 62% capitated rates.


Mail Order Pharmacies. During the same period, the late 1980s and early 1990s, mail order pharmacies also emerged. These organizations tended to serve specific groups, e.g., the elderly, who needed to have prescriptions refilled regularly but who did not need instruction on the proper use of the drug, side effects, etc.

Eventually more than 100 companies entered the mail-order market (McGahan, 1994, 119). In 1994, 29 of the 34 (85%) PBMs that were examined reported offering mail-order drug plans as part of their core of services. Twenty-two of them offered the service directly while 7 offered the service through a subcontract.


Mergers. The environmental changes that were discussed earlier transformed a relatively stable, certain, and profitable industry into a turbulent and uncertain one. As a result, in the early 1990s, pharmaceutical firms began to experience a decline in profits, became more vulnerable to the changing environment, failed to secure needed resources, e.g. customers, and became increasingly dependent in the organization-environmental relationship (McGahan, 1994).

In an uncertain and turbulent environment, resource dependence theorists argue that organizations may adapt their structure, information system, pattern of management and human relations, technology, products, values and norms, or their definition of the environment (Pfeffer & Salancik, 1978). And, in attempting to affect the environment, organizations can select from a wide array of strategies. For example, they can diversify, alter the environment through mergers, or attempt to manage it through cooptation (Pfeffer & Salancik, 1978). All of these strategies have the same goal: to reduce the level of environmental uncertainty and the level of dependence upon other actors/organizations for needed resources.

As an organization's environment becomes increasingly unstable and uncertain, mergers are one mechanism that firms can use to achieve increased stability and certainty as they attempt to manage their organization-environment relationships (Katz & Kahn, 1966). Pfeffer & Salancik (1978) argue that a vertical merger represents a mechanism by which an organization can extend control over exchanges that are critical to its operation.

Five mergers have occurred in the drug industry, 4 since August, 1993. Three of the mergers involved drug manufacturers and PBMs and represented vertical integration. In August, 1993, the drug manufacturer, Merck & Co., Inc. bought Medco Cost Containment Services, a PBM that covered 11 million lives, for $6 million. The second merger occurred in May, 1994 when SmithKline Beecham, another manufacturer, bought Diversified Pharmaceutical Services, Inc., a PBM that covered 38 million lives, for $2.3 billion. The final vertical merger occurred in July, 1994 when the drug manufacturer, Eli Lilly & Co, bought PCS Health Systems, Inc., a PBM covering 50 million lives, for $4 billion (Woolsey, 1994). [Recently, Merck-Medco Managed Care announced its intent to purchase the Los Angeles-based PBM, Systemed Pharmacy which, in 1995, had sales of $152 million. However, the FTC may intervene to block the merger (Muirhead, 1996)].



PBMs. In 1993, MCOs accounted for 50 percent of the drug market; by the year 2003, the figure is projected to increase to 90 percent (O'Reilly, 1993). PBMs have become important players in facilitating the growth of managed care in the pharmaceutical industry. However, PBMs can have both positive and negative effects on the delivery system. On the one hand, they are specialized organizations that have specific ready-made programs, e.g., formularies, report cards, mail-order prescription services, to offer employer clients. They operate through a large network of pharmacies and can obtain volume discounts on drugs. Moreover, many have the financial resources to purchase and maintain state-of-the-art technology such as reporting systems and databases (Reissman, 1995).

On the other hand, PBMs can add another layer to the health care delivery system and, as a result, they may have the net effect of pushing up administrative costs. In addition, although the technology such as the database may be state-of-the-art in principle, it is not clear that the information collected can be used to conduct such important tasks as a comprehensive outcomes program. Finally, PBMs may experience the double agent problem in that they may not always, themselves, be clear about who is the primary client/interest to be served. For example, a PBM may contract with an employer or an MCO to provide managed pharmacy services to patients or employees. At the same time, a PBM may be involved in an interorganizational relationship with a drug manufacturer. These sets of relationships may present conflicting interests for the PBM.


Vertical Mergers. As discussed above, vertical integration is one way that a firm can gain control over exchanges that are critical to its operation. For example, by integrating, PBMs stand to gain more bargaining power with employers and MCOs as they bundle pharmaceuticals with insurance services (McGahan, 1994). This feature of PBMs may make them attractive to MCOs, hospitals, and employers who may be more likely to enter into contracts with them.

Moreover, by vertically integrating pharmaceutical manufacturers may also seek to control the exchanges that are critical to their survival. First, PBMs collect data on physicians' and pharmacists' prescribing patterns as well as on drug utilization by patients. These data can be used to generate information about drug efficacy which, in turn, can be used to market drugs to physicians who prescribe drugs. Second, PBMs can promote the parent/ manufacturer's comparable products that are offered at competitive prices thereby expanding the parent's customer base (McGahan, 1994).

Finally, PBMs provide drug manufacturers with an opportunity to engage in product development that they might not otherwise have. For example, PBMs can develop new approaches to risk-sharing such as capitation and disease management programs. Through approaches such as disease management, information about the characteristics of individuals who require specific pharmacologic intervention can be obtained. The PBM can then use this information to develop new marketing strategies for its parent's product. For its part, the drug manufacturer can market its drug more efficiently, e.g., by using a smaller sales force (McGahan, 1994).

On the other hand, since 1994, the Federal Trade Commission (FTC) has carefully scrutinized mergers between drug manufacturers and PBMs for several important reasons. First, independent community pharmacists, in a class action lawsuit, have charged the drug manufacturer/PBM alliances with price fixing and price discrimination (Cohen and Tanouye, 1996). Discounting began in the late 1980s when manufacturers began offering sizeable discounts to large volume buyers such as HMOs, chain drug stores, and pharmaceutical mail-order firms. The independent pharmacies claim that such discounting practices have hurt the pharmacy business and have made the purchase of needed drugs costly for consumer groups, such as the elderly on Medicare, who pay out-of-pocket for medication. Moreover, any settlement of the 1994 drug retailers' lawsuit raises fears that manufacturers may simply pass on the settlement costs to consumers through higher prices (Cohen and Tanouye, 1996).

The future of discounting practices will depend on whether the practices violate the Robinson-Patman Federal Act. In April, 1996, the FTC began an investigation of drug manufacturers in order to determine if the manufacturers had conspired to fix prices (Snyder, 1996).

Related to the issue of insuring price competition, in 1994, as part of a settlement of a California lawsuit that challenged the merger of Merck & Co. and Medco Containment Services, Inc., the FTC required the merged firms to institute two structural changes. First, they required PBMs that merge with a drug manufacturer to keep their formularies open to other drug manufacturers' products. In addition, the FTC required PBMs who obtain price information from manufacturers in the course of administering pharmacy benefit plans to keep that information separate from their parent/drug manufacturer's information database (Gebhart, 1995). This was designed to prohibit a parent/manufacturer from obtaining information on competitors' bids for pharmacy contracts.

Other concerns have been raised that the drug manufacturer/PBM alliances might authorize the use of their own program specific generic drugs which could then, potentially, become quasi brand name drugs. As a result, competition in the generic marketplace would be reduced and the prices of generic drugs to consumers would increase (McGahan, 1994).

Finally, in 1994, the National Association of Chain Drug Stores argued before the FTC that the three drug manufacturers that had merged with PBMs would control 80% of the PBM market if the mergers were not prohibited. As a result, only 20% of the PBM market would be available for alternative therapeutic products that were offered by the remaining drug manufacturers (Conlan, 1994).



The purpose of PBMs is to provide services, to employers and MCOs, that will control the types and distribution methods of prescriptions used by plan participants. This paper presented early data on PBMs, described their role in the managed care market, and examined the changed environment in which they operate.

The degree to which the goals of the firms in the prescription drug industry can be achieved may be determined by the extent to which they are able to secure needed resources from the environment. Since the environment in which pharmaceutical companies operate is complex and turbulent, high levels of uncertainty exist for them. Resource dependence theory suggests that the formation of interorganizational relationships, e.g., mergers, is one strategy that firms can use to reduce environmental uncertainty.

Although the vertical integration that has occurred in the industry has certain advantages for both drug manufacturers and PBMs, it may present potential problems for the prescription drug marketplace as a whole. The major concern is whether the mergers will result in levels of market concentration that will ultimately reduce competition in the industry and raise prices to consumers.



Annual Directory of Prescription Benefit Management Companies. (1995, April 3). Business Insurance. Chicago, IL: Crain Communications, Inc.

Business & Health Special Report. (1995). Montvale, NJ: Medical Economics.

Cohen, L. P., & Tanouye, E. (1996, January 18). Bitter pill: Drug makers set to pay $600 million to settle lawsuit by pharmacies. The Wall Street Journal, A1, A8.

Conlan, M. F. (1994, October 24). NACDS urges FTC to kill PCS-Lilly deal, review others. Drug Topics, 16.

Doubts emerge about drug industry mergers. (1994, November). Business & Health, 53-61. [Correction: Business & Health (1995, February), 7.]

Gebhart, F. (1995, March 20). Merck OKs fire wall. Drug Topics, 59.

Katz, D., & Kahn, R. L. (1966). The social psychology of organizations. New York: Wiley.

McGahan, A. M. (1994, November-December). Industry structure and competitive advantage. Harvard Business Review, 115-124.

Muirhead, G. (1996, May 20). Merck-Medco to buy Systemed to expand market share. Drug Topics, 17-18.

O'Reilly, B. (1993, September 20). Why Merck married the enemy. Fortune, 60-64.

Pfeffer, J., & Salancik, G. R. (1978). The external control of organizations: A resource dependence perspective. New York: Harper & Row.

Reissman, D. (1995, July-August). Contracted pharmacy services: The value of a carve-out PBM. HMO Magazine, 57, 60-61.

Snyder, K. (1996, April 8). FTC opens probe of possible drug price fixing. Drug Topics, 24.

Woolsey, C. (1994, July 18). Any adverse effects? Business Insurance, 1, 94.



Lucy Canter Kihlstrom, PhD

Copyright 2000 Institute for the Study of Healthcare Organizations & Transactions

Last modified:  04.08.2010 02:58 PM