How to Organize Tiered Competition for Prescription Drugs?: Formulary Structure and Bargaining Process

Most prescription purchases in the US are covered by health insurance. Insurance companies typically develop a formulary structure to reduce the drug costs and improve patients’ access to drugs. In this paper, we study how the formulary structure affects price competition between competing drugs, which in turn affects market shares and the total market size. We characterize an insurance plan’s optimal strategy in terms of the number of drugs in the formulary, patients’ copay amount, and the structure of the bargaining process. We develop a game-theoretic model of strategic interactions among an insurance plan and two manufacturers of competing patent-protected drugs. The insurance plan in our model can negotiate prices with each drug company in return for providing insurance coverage to their products. We show that the insurance plan’s ability to accomplish cost- and access-related objectives varies significantly across different formulary structures and bargaining processes. Specifically, the insurance plan can better meet its objectives by putting both drugs in the formulary when the cross-price effects are not very large. On the other hand, when the cross-price effects are sufficiently strong, the insurance plan’s optimal strategy is to include only one drug in the formulary. Our analysis further suggests that sequential bargaining is better for the insurance plan than simulatenous bargaining. Although some of the gains to the insurance plan come at the expense of drug companies, there are cases in which the creation of a formulary may also benefit one or both drug companies, resulting in a win-win situation.