Pharmacy Benefit Managers Explained: Evolution of PBMs and Their Role in Negotiating Drug Costs

Over 90 percent of Americans with prescription drug insurance coverage have their benefits managed by a Pharmacy Benefit Manager (“PBM”), making these entities a critical, yet often less-understood, component of the U.S. healthcare system. PBMs are third-party administrators hired by health plans—including those offered by employers as well as Medicare and Medicaid—to manage their prescription drug benefit programs.

PBMs negotiate with drug manufacturers and pharmacies to manage their clients’ costs for prescription drugs. These negotiations play a significant role in determining the cost of prescription drugs for both health plans and their beneficiaries (i.e., patients). Notwithstanding their stated aim to reduce prescription drug costs and increase efficiency of prescription drug utilization, in recent years, their operations have sparked policy debates and regulatory scrutiny, with critics arguing that PBM practices drive up costs and limit patient access to medications.

History and Evolution of PBMs

PBMs emerged in the late 1950s, focusing on processing prescription drug claims. Before the establishment of PBMs, health plan beneficiaries paid cash for a prescription at the pharmacy, sent their receipt to the insurer, and then waited to be reimbursed. PBMs reduced the burden on beneficiaries by issuing identification cards that allowed beneficiaries to pay only the member-portion of the prescription cost at the pharmacy. PBMs also aggregated the purchasing power of multiple health plans when bargaining with pharmacies for reimbursement amounts. Pharmacies who opted into a PBM’s network would receive higher prescription volumes in exchange for discounted reimbursements.

The Employee Retirement Income Security Act (“ERISA”) of 1974 allowed large employers to develop and deploy cost containment strategies, including hiring PBMs to manage their prescription drug benefits. As a result of the ERISA and other changes in legislation as well as rising drug prices, health insurers increasingly hired PBMs in an effort to contain their prescription drug costs. The 1980s and 1990s saw the emergence of full-service PBMs, whose main functions expanded from prescription claims processing and pharmacy network maintenance to include additional cost containment services such as formulary design, drug utilization management, and negotiating discounts and rebates from manufacturers.

In 1995, there were more than 40 PBMs. A directory issued the following year by Managed Healthcare listed 79 PBMs. There are currently 66 PBMs in the United States. The three largest PBMs—CVS Caremark, Express Scripts, and OptumRx—were estimated to represent approximately 34 percent, 23 percent, and 22 percent of claims managed, respectively, in 2023. The next three largest PBMs—Humana Pharmacy Solutions, MedImpact, and Prime Therapeutics—collectively represented 15 percent of claims.

How PBMs Operate Today

PBMs operate at the intersection of multiple stakeholders in the healthcare system, including pharmaceutical manufacturers, insurance companies, pharmacies, and patients. The portfolio of services provided by a PBM includes:

• Developing and Maintaining Formularies: One of the central functions of a PBM is to develop and maintain drug formularies for its health plan clients, which include insurance companies, employers, unions, and government agencies. Formularies determine the drugs that are covered by health plans and the level of patient cost sharing. Cost sharing is often in a tiered system, with generic drugs typically having the lowest patient cost (e.g., lowest copayment) and non-preferred brand name drugs having the highest. Formularies can be open or closed—open formularies have few restrictions on covered drugs, while closed formularies cover only a specific list of drugs and focus on utilization management and controlling cost. PBMs typically develop multiple standard formularies, some with more emphasis on value (i.e., low premiums) while others offer better coverage (i.e., fewer exclusions and restrictions). A health plan client can choose to offer one or more of the standard formularies or work with the PBM to develop its own customized formularies. Typically, formularies are updated annually but can change during a plan year because of drug therapy changes, new drugs, or new medical information.
• Utilization Management: In developing formularies, PBMs often incorporate various tools to control patients’ utilization of medications, such as prior authorization, step therapy, and quantity limits. These tools are designed to ensure that medications are used appropriately and cost-effectively. PBMs also conduct drug utilization reviews to evaluate and improve the prescribing, administration, and use of medications by physicians and patients.
• Negotiating and Processing Rebates: PBMs negotiate with drug manufacturers to secure discounts, rebates, and other price concessions for their health plan clients. These negotiations are often based on the inclusion of a drug in the PBM's formularies. For example, higher rebates may be offered in exchange for preferred tier status and fewer utilization management restrictions.
• Processing Prescription Claims: PBMs handle the administrative side of prescription drug benefits, including claims processing, payment, and coordination of benefits. This function ensures that patients receive their medications in a timely manner and that pharmacies are reimbursed for dispensing drugs.
• Pharmacy Network Management: PBMs establish networks of pharmacies that agree to certain pricing and reimbursement terms. These networks can be broad, including a wide range of pharmacies, or narrow, such as including only those that offer the lowest prices.
• Mail Order Pharmacy and Specialty Pharmacy Services: Many PBMs, including the three largest, own and operate mail-order pharmacy facilities that automatically fill and ship medications in 90-day supplies. They also maintain specialty pharmacies that dispense high-cost, high-touch medication therapy for patients with complex diseases, such as injections, infusion therapy, or biologics for conditions including cancer or multiple sclerosis.

PBMs are compensated for their services in several different ways that can vary across their client base, depending on each client’s particular goals or circumstances. One approach is to charge administrative fees for their services. Another approach is the use of “spread pricing,” where a PBM keeps the difference between what is paid to pharmacies and the negotiated payment from health plans. PBMs may also keep part of the rebates or discounts negotiated with drug manufacturers and share the remainder with clients. For PBMs that operate mail order pharmacies and specialty pharmacies, these operations also make up a part of the PBMs’ profit streams.

While many of PBM functions aim to contain the costs of prescription drugs, many of these same functions have become the center of debate. The second installment of Pharmacy Benefit Managers Explained gives an overview of the views of both critics and advocates, including debates on transparency, incentives, concentration, and patient access.