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By Amy Merrick and Jane Zhang

March 28, 2007

John Mitchener, owner of Mitchener's Pharmacy in Edenton, N.C., is worried a new Medicaid reimbursement rule will force him to drop some of the customers who need him most -- a couple of truck drivers with diabetes, several people who can't read and a woman who always comes in near closing to avoid crowds because her multiple sclerosis has made her unsteady on her feet.

"These are real, live human beings," he says, referring to the 30% of his patients who get Medicaid. "I do not want to be put in the position where I have to say that I cannot fill your prescription anymore because the government pays so little."

Drugstores are fighting a proposal in the latest White House budget to slash reimbursements for generic drugs under the federal-state health program for the poor and disabled -- which they say would affect their ability to go on filling those prescriptions and ultimately force many small pharmacies to close their doors, hurting the neediest customers.

The government's proposal, mandated by the 2005 Deficit Reduction Act, is aimed at saving the joint federal-state Medicaid program $8.4 billion over five years. The savings would come mainly through changing how the government calculates reimbursement to pharmacies, including around 18,000 small pharmacies with $6.5 million or less in annual revenue. The federal Centers for Medicare and Medicaid Services, which administers Medicaid and put forth the proposal in December, is required by law to finalize the new rule on Medicaid reimbursements by July 1.

The plan already has sparked a firestorm in Washington. The agency has received more than 1,000 responses to the proposal. Many of them are objections from unusual allies: pharmacies, makers of generic drugs and pharmacy-benefit managers, whose interests often are at odds. Congress has jumped into the fray. Pharmacists question why they're being asked to bear those cuts -- which make up more than 90% of the proposed Medicaid cuts over the five-year period -- when pharmacy expenses are only 3% of the total Medicaid budget.

"This is probably the most crucial issue that this industry has ever faced," says Bruce Roberts, chief executive of the National Community Pharmacists Association, the lobbying group that represents independent pharmacies.

The controversy over the new rule centers on the definition of an "average manufacturer price" used to calculate the reimbursements pharmacies receive for generic drugs. Under the new proposal, for the first time the reimbursement formula would include an average manufacturer price that takes into account mail-order prices and rebates to the big pharmacy-benefit managers, or PBMs, that administer drug benefits for large employers and health plans.

But retail and independent pharmacies, where most Medicaid beneficiaries buy their drugs, don't get those rebates and discounts.

The government pays for Medicaid prescriptions in two ways: The federal government reimburses the pharmacy for the cost of the medication, while the state pays the pharmacy a dispensing fee, which is supposed to cover the portion of the pharmacist's salary and store operations that are used to fill the prescription.

While some generic drugs do provide significant profits to pharmacies, retail pharmacists don't always make money on them. The independent-pharmacists group offers an example from a pharmacy in Alabama. It pays $3.56 to purchase 60 tablets of the generic indomethacin, a commonly prescribed anti-inflammatory drug. The federal government reimburses the pharmacy $4.48. In Alabama, the state dispensing fee is $5.40 per prescription, but the average dispensing cost to the pharmacy is $11.35, according to a study by the accounting firm Grant Thornton. Add it up, and the pharmacy loses $5.03 on filling the prescription.

The new Medicaid rule is expected to make such gaps worse, though the government has yet to release the reimbursement rates it will pay for specific drugs.

A report by the Government Accountability Office aimed at determining the effect of the new rule found that reimbursements wouldn't even cover pharmacies' costs of buying many drugs, let alone the cost of dispensing them. The report -- based on confidential pricing information that pharmacists aren't allowed to review -- says reimbursements would be, on average, 36% below the cost that a pharmacy pays a wholesaler for the drug, meaning many pharmacists couldn't afford to fill such prescriptions for Medicaid recipients.

Leslie V. Norwalk, acting administrator of the Centers for Medicare and Medicaid Services, says the GAO report is flawed because it didn't use a uniform definition of the average manufacturer price. "Without a definition, the numbers are meaningless," she says. The GAO responds that it used the most complete and accurate data sources available.

In its proposal, the Centers for Medicare and Medicaid Services said it hasn't yet determined exactly what the effect of the new regulation would be. Although the changes would have only a small impact on most pharmacies, the proposal said, "we are unable to estimate quantitatively effects on 'small' pharmacies, particularly those in low-income areas where there are high concentrations of Medicaid beneficiaries."

Mark Merritt, president of the Pharmaceutical Care Management Association, a trade group for PBMs, says mail-order prices and PBM rebates should be excluded because of the problems that would pose for pharmacies, among other reasons. "PBMs rely on chain and independent pharmacies alike to provide access to prescriptions for their government and commercial clients, and would not want to see that access put in jeopardy," he wrote in a comment on the proposal.

Big chains such as Walgreen Co. and CVS Corp. also object to the plan. A lower reimbursement "can reduce the incentive to dispense generics," says Michael Polzin, a spokesman for Walgreen, where Medicaid reimbursements account for 10% of pharmacy sales. If, as a result, patients begin buying more brand-name drugs, "that can have the effect overall of costing Medicaid more money than they're saving," he says. Mr. Polzin adds that Walgreen might have to cut costs, perhaps by limiting operating hours, at pharmacies with a high proportion of Medicaid patients.

Actuaries for the agency that administers Medicaid figure that under the new formula, pharmacies would likely lose $800 million in revenue from Medicaid this year and $2 billion annually by 2011. The agency argues that the cuts would represent only a small portion of pharmacy revenue. Total retail prescription sales in 2005 reached $230 billion in 2005, including chains, independents, supermarkets and mail-order, the government says.

But the cuts could hit particularly hard at independent pharmacies, which get an average of 92% of their revenue from dispensing prescriptions. Medicaid revenues make up one-fifth of the average independent pharmacy's business; for some, it's more than 50%. Many of these pharmacies are in rural areas and have little or no competition.

In a survey of independent pharmacists, 86% say they will consider not filling Medicaid prescriptions if the proposal goes through as it is. If so, some customers might have to wait at an emergency room or drive miles to get their medications, while others might not have any practical alternative.

Two weeks ago, 46 senators, both Democrats and Republicans, sent a letter asking that the reimbursement plan be revised.

Meanwhile, the National Community Pharmacists Association says it is meeting with officials in Congress and working with state governments to try to increase dispensing fees, to make up some of the predicted shortfall.

Ms. Norwalk says the agency is reviewing the comments it has received, but she declined to predict what the final rule will look like. "We appreciate the importance of generic drugs and state Medicaid programs, and want to encourage their use," she says.

Write to Amy Merrick at amy.merrick@wsj.com and Jane Zhang at Jane.Zhang@wsj.com