The Incredibly Slow (But Very Nearly Certain) Death of AWP

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Richard Evans / Scott Hinds / Ryan Baum


203.901.1631 /.1632 / .1627 richard@ / hinds@ /


January 15, 2013

The Incredibly Slow (But Very Nearly Certain) Death of AWP

  • We’ve long held that use of the Average Wholesale Price (AWP) benchmark in commercial drug benefit contracts has enabled outsized generic dispensing margins in the drug trades (PBMs, drug retail, drug wholesale); and, that the replacement of AWP by either of the alternatives (Average Manufacturer Price or “AMP”; National Average Drug Acquisition Cost or “NADAC”) called for in the Affordable Care Act (ACA) will result in falling generic dispensing margins
  • In order for AWP to be abandoned as the commercial benchmark, it must first be abandoned as the Medicaid pricing benchmark by the federal government, and by a convincing majority of the states
  • Three states (Alabama, Idaho, Oregon) have formally abandoned AWP in favor of Average Acquisition Cost (AAC), a close cousin to NADAC; eight more states have announced decisions to follow suit. These 11 states account for 42 percent of national Medicaid spending
  • Many other states are in advanced stages of replacing AWP; for example Medicaid agencies in both Mississippi and Utah have asked their legislatures to authorize a shift to AAC/NADAC
  • A recent posting by the Centers for Medicare and Medicaid Services (CMS) establishes August 2013 as the likely date on which CMS will: 1) replace Wholesale Acquisition Cost (WAC, a close cousin of AWP) with AMP as the basis for its calculation of the maximum amounts states may pay pharmacies for Medicaid prescriptions; and 2) make NADAC an official alternative to AWP for the states
  • For technical reasons explained in this note, CMS’ action should catalyze adoption of AAC/NADAC by the states. States’ fiscal 2014 begins on July 1, 2013; we expect many states will officially replace AWP (and adopted AAC/NADAC) by July 1st
  • The steps to replacing AWP are becoming increasingly concrete; however most of the negotiations for 2014 commercially sponsored drug benefits will be finished by the time CMS’ rule is official this August. As a result, widespread displacement of AWP as the commercial pricing benchmark is unlikely to occur before 2015

The Affordable Care Act (ACA) provides for two replacements to Average Wholesale Price (AWP), the ingredient cost reimbursement benchmark currently used by Medicaid. The first is Average Manufacturer Price (AMP), an index of the price at which manufacturers sell to certain points of the drug supply chain; the second is National Average Drug Acquisition Cost (NADAC), an index of prices paid by retail pharmacies to acquire drugs from manufacturers or wholesalers[1]

It now appears that AMP will be officially adopted as a basis for calculating Federal Upper Limits[2] (FULs) by August 2013. This likely catalyzes states’ adoption of an alternative to AWP[3] as a basis for calculating state-level Medicaid reimbursement; NADAC is the probable new standard for states. A version of NADAC (average acquisition cost, or AAC) already is in place in three states (Alabama, Oregon, Idaho); eight more states have indicated decisions to switch to AAC/NADAC. The 11 states that already have switched or decided to switch represent 42 percent of national Medicaid drug spend. Many more states are in the process of evaluating AAC/NADAC; several of these states have officially recommended the adoption of AAC/NADAC to their state legislatures

We believe most states will want to have AAC/NADAC in place as an official alternative to AWP ahead of CMS’ final rule in August 2013; specifically by the beginning of the states’ fiscal year on July 1, 2013

Once AWP is no longer used by state Medicaid programs, AWP would only remain in use if commercial plan sponsors purposefully choose AWP over the alternatives – either AMP or AAC/NADAC. Because both AMP and AAC/NADAC are far more indicative of true acquisition costs than AWP, we expect commercial plan sponsors will also abandon AWP, and that AWP will no longer be used as a pricing benchmark – in either government or commercial contracts. The loss of AWP puts generic dispensing margins under pressure, and this is a key element of our bearish thesis on the drug trades, particularly PBMs. However, because the start of states’ fiscal 2014 and the date for CMS final rule occur very late in the annual negotiating season, the majority of commercial contracts in the 2014 benefit year will in all likelihood still be benchmarked to AWP

What’s Happening at the Federal Level

The Centers for Medicare and Medicaid Services (CMS) have been publishing AMP prices since September 2011, and NADAC prices since October 2012. Nevertheless CMS has yet to make either of these AWP alternatives an official option for states’ use in setting Medicaid reimbursement; and, CMS has not yet shifted the basis of its calculation of Federal Upper Limits (FULs) from published prices to AMP as called for by the ACA

FULs are price limits on Medicaid prescription drugs, set by CMS, which any given state cannot exceed in the aggregate. These are currently based on published prices[4], typically Wholesale Acquisition Cost (WAC). WAC is essentially list price; brands generally are sold to the drug trades at WAC, however generics are generally sold to the drug trades at very large discounts to WAC. As a result, setting FULs on the basis of WAC tends to result in substantial overpayment. A study[5] published by the HHS Office of Inspector General (OIG) in October of 2012 found that current WAC-based FULs are approximately 4 times greater than pharmacies’ acquisition costs

The ACA calls for FULs to be set on the basis of AMP. Because AMP (as compared to WAC) more closely mirrors true acquisition costs, AMP-based FULs are roughly 61 percent (at the median) lower than current WAC-based FULs. The OIG recommended in October of 2012 that CMS make a final and official switch to AMP-based FULs; acting CMS Administrator Tavenner has endorsed the OIG’s findings and committed the agency to making the switch “in the near future”. Very recently, CMS posted a notice[6] on the website of the Office of Information and Regulatory Affairs; the notice indicates that an official switch to an AMP basis for FULs (among other drug related policy changes) will occur in August of 2013

CMS’ official adoption of AMP as a basis for FULs is occurring much later than we expected; however despite the delay it’s important to recognize the impact of this switch on states’ adoption of alternatives to AWP. The states are generally free to choose their own benchmark for Medicaid prescription reimbursement (and are accordingly free to stick with AWP or WAC), and also are generally free to reimburse specific drugs at whatever level they choose; however each state’s reimbursements must remain below FUL in the aggregate. Once FULs are set on the basis of AMP (an acquisition cost benchmark) instead of WAC (a list price benchmark), states will be unable to reliably keep their aggregate spending within FUL limits unless they adopt an acquisition cost benchmark (AMP, or AAC/NADAC) as their standard for reimbursing pharmacies. Thus it follows that the pending switch to AMP-based FULs by CMS almost certainly catalyzes a corresponding switch from AWP to any of the acquisition cost-based alternatives by the states that have not yet made such a switch. August is quite a few months away; however states’ fiscal 2014 begins July 1st, and states presumably will want to have officially adopted an AWP alternative by the start of the new fiscal year

What’s Happening in the States

The Supreme Court review of the ACA, concerns regarding ACA’s longer-term fate ahead of the general election, and the fact that CMS was enjoined by the federal courts from shifting to AMP based FULs under previous legislation have probably all served to slow states’ adoption of the AWP alternatives. Despite its slow progress in making the AWP alternatives official, CMS has made its ultimate intentions regarding AWP very clear since the passage of ACA, and has provided states with a relatively straightforward path to incorporating NADAC as an alternative to AWP

The anticipated shift by CMS to AMP-based FULs, coupled with the significant savings achieved by early adopters of AAC, have prompted momentum away from AWP. Alabama, Idaho, and Oregon have implemented Medicaid drug reimbursement formulas based on AAC, which is a nearly identical mirror of NADAC. These states are effectively demonstration programs for the broader NADAC initiative[7]

In July and August of last year – before the general election – the Kaiser Family Foundation and Health Management Associates surveyed states’ planned Medicaid policies; in this survey (or in an earlier survey conducted by the Office of the Inspector General) eight additional states[8],[9] indicated that they had decided to shift to AAC. Collectively, these eleven states represent 42 percent of national Medicaid spending

The Kaiser survey largely reflects states that have made a final decision – or very nearly so – to switch to AAC; many states in which the AAC shift is under active consideration are not counted in the survey. Because states take varied approaches to disclosing ongoing internal assessments, we have no systematic way to comprehensively determine where all states stand in their assessment of AWP alternatives. However by searching states’ disclosures we were quickly able to establish that, for example, both Utah and Mississippi Medicaid agencies have recommended adoption of AAC to their state legislatures; that other states (e.g. Alaska) have completed surveys of acquisition and dispensing costs as steps toward recommending an AAC switch; and that still others (e.g. Virginia) seem to be preparing for a switch in anticipation of HHS establishing NADAC as an official alternative to AWP

Thus even in advance of HHS having officially incorporated either AMP or NADAC into Medicaid reimbursement policy, states representing more than half of total Medicaid drug spend have either adopted AAC (essentially the same as NADAC), made the formal decision to adopt AAC, or appear to be in late stages of a process that is likely to end in the adoption of AAC

Why This Matters to Investors

If the states abandon AWP – as they are slowly but surely doing – commercial plan sponsors ultimately will abandon AWP as well. Because AWP is largely unrelated to true generic acquisition costs, the use of AWP as a pricing benchmark enables outsized generic dispensing margins. Replacing AWP with either AMP or NADAC – both of which are much more tightly related to true acquisition costs – accordingly is likely to lead to a narrowing of generic dispensing margins. PBMs in particular, drug retailers, and to a lesser degree drug wholesalers have become heavily reliant on generic dispensing margins, thus at a minimum the replacement of AWP by AMP and/or NADAC forces these industries to re-price their service offerings

Legal and timing risks still remain. The drug trades successfully enjoined CMS from implementing a prior version (called for in the Deficit Reduction Act of 2005) of AMP-based FULs, and the trades are again challenging[10],[11] CMS’ authority to proceed with AMP-based FULs and NADAC under the authority granted by the ACA. In successfully attacking CMS’ authority to base FULs on AMP under DRA ’05, the trades argued that CMS was redefining AMP and making AMP public in manners not authorized, and that in doing so pharmacies would be irreparably harmed[12]. The ACA language authorizing AMP-based FULs and NADAC appears to have been carefully written in light of the DRA ’05 outcome, making CMS’ authority to recalculate and publish AMP very clear. And, CMS has been careful to establish the likely effects of AMP-based FULs and NADAC through a number of studies and demonstrations. Accordingly the weaknesses that allowed the trades to block AMP-based FULs appear to have been thoroughly addressed. The matter of whether the trades can find legal weaknesses in CMS’ current approach to AMP and NADAC is unclear; however our lay reading of the trades’ letters to CMS, and the fact that nearly three years have passed since the ACA became law, argue that the trades are relatively unlikely to prevent CMS from implementing either AMP-based FULs or NADAC

Timing risks take several forms. It’s clear from CMS’ posting that the final rule is likely to be published in August 2013. It stands to reason that states, if at all possible, will want to have authorized a shift to AAC/NADAC by the start of their fiscal 2014 (July 1, 2013), both in order to capture the available savings, and to be able to synchronize their pharmacy reimbursement standards with a system of AMP-based FULs. With states representing nearly half (42 percent) of Medicaid drug spend already having switched, or having decided to switch to AAC/NADAC, we’re reasonably confident that states representing a substantial majority of Medicaid drug spend will have officially decided to shift to AAC/NADAC by the middle of this year

Despite the steady march of the Medicaid program away from AWP, there remains a high likelihood that negotiations for 2014 commercial drug benefits will be largely complete before a substantial majority of states have abandoned AWP, and/or before it’s clear that the trades represent no more than a trivial legal risk to CMS’ authority. It follows that a large scale shift away from AWP in commercial contracts is unlikely for the 2014 benefit year. At most, we would expect larger, more sophisticated commercial buyers’ whose contracts are up for renegotiation this year to structure their contracts in such a way that AWP alternatives can be brought in as benchmarks under certain conditions, such as formal steps by CMS establishing NADAC as an official replacement (or alternative) to AWP, adoption of NADAC by a majority of states, and/or the general availability of NADAC in claims adjudication and payment processing systems at the retail pharmacy level

  1. For a more detailed review of the AWP alternatives, please see: “A Detailed Comparison of the AWP Replacements: AMP v. NADAC” SSR llc, October 4, 2011
  2. FULs are maximum reimbursement levels for drugs prescribed to Medicaid beneficiaries. States can pay more (or less) than FUL for any given drug, but cannot exceed FUL in the aggregate
  3. AWP and WAC are very closely related – AWP is simply 1.2x WAC. Various statutes, regulations, and standard practices will incorporate one or the other benchmark specifically by name; however which of these is used isn’t strategically relevant. The issue with both benchmarks is that they are based on list price rather than acquisition cost. Because generic acquisition costs are substantially lower than list price, and because the gap between list price and acquisition cost is of unpredictable magnitude for any given generic drug, the use of either AWP or WAC creates an information symmetry that favors the drug trades (who know true acquisition costs) over plan sponsors (who cannot see true acquisition costs in real time, hence sponsors tend to overpay for generic drugs when AWP or WAC is used as a benchmark)
  4. Equal to 1.5x the lowest published price for therapeutic equivalents available in quantities of 100
  5. “Analyzing Changes to Medicaid Federal Upper Limits” Department of Health and Human Services Office of Inspector General, October 2012, OEI-03-11-00650
  7. Alabama switched to AAC in October of 2010, Oregon in January of 2011, and Idaho in October of 2011. All states have seen considerable savings; in April 2011 we estimated that Alabama’s saved 37% per generic Rx due to the shift to AAC: see
  8. California, Colorado, Delaware, Iowa, Louisiana, New York, Texas, Wyoming
  9. California (9.9% of national Medicaid drug spend) has been in and out of the ‘shift to AAC’ column. The most recent information we have is that the bill containing the statutory language to effect the shift (AB 399) is as of August 16, 2012 in the California Senate’s Committee on Appropriations
  10. The National Community Pharmacists Association (NCPA) has challenged CMS’ authority to implement NADAC, and has also challenged CMS’ approach to NADAC should it eventually be implemented. NCPA’s letter to CMS can be found here:
  11. NCPA’s criticisms of changes to the Medicaid drug reimbursement process generally, and AMP-based FULs specifically, can be found here:
  12. The District of Columbia’s US District Court granted a preliminary injunction barring implementation of an AMP-based rule for Medicaid reimbursement on December 19, 2007, less than one year after the underlying legislation had been signed into law (Deficit Reduction Act of 2005, signed February 8, 2006). The motion was filed by the National Association of Chain Drug Stores and the National Community Pharmacists Association; the compliant can be found here: The district court ruling can be found here:
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