Brand name drugs are typically more expensive than generic versions of the same drug, which in general have identical therapeutic effects. The Food and Drug Administration (FDA) evaluates and approves the bioequivalence of generic drugs. Controversy persists about the bioequivalence of a handful of medications, but nearly all other generic drugs provide identical therapeutic benefit.

State Medicaid programs provide health care coverage to those defined as either “categorically needy,” whose coverage is federally mandated, or “medically needy,” as determined by each state. Medicaid coverage includes prescription drugs in every state. Since 1987, the Health Care Financing Administration has set upper limits on Medicaid payment for certain drugs which are generically available from multiple sources and have been deemed therapeutically equivalent by the FDA (Nightingale 1998). These prices are referred to as Federal Upper Limit (FUL) prices, and are aimed at encouraging use of generic drugs in state Medicaid programs. States have some discretion in how they apply these price formulas; the various state payment plans are referred to as Maximum Allowable Cost (MAC) programs (National Pharmaceutical Council 1998). For drugs with these limits, Medicaid will only reimburse the pharmacy for the MAC price, regardless of whether generic or brand name product is dispensed. There may be exceptions to these limits if the prescribing physician indicates that the brand name drug is medically necessary. Federal law also requires drug manufacturers to negotiate rebate arrangements with state Medicaid programs; these rebates are based on the average manufacturer's price for a drug and are generally slightly higher for brand name than for generic drugs (National Pharmaceutical Council 1998).

Using aggregated state-level reimbursement data from the national Medicaid program, we sought to estimate potential savings from broader use of generic drugs and assess differences across states in spending on brand name and generic medications.

Our analysis of the potential savings using the best MAC price available across states is summarized in Table 2. The total potential savings almost double, to a total of $450 million dollars, representing 11.9 percent of spending on drugs available in both brand and generic forms and 2.1 percent of total drug expenditures. The amount by which the potential savings increase varied from state to state. For example, the potential savings in Ohio increased by 29.6 percent ($3.4 million in absolute terms) while the amount in California more than doubled (absolute increase of $31.7 million).

Much of the excess costs found result from prescriptions for which the physician specifically requested a brand name drug as “medically necessary.” The pharmacologic rationale for such a decision in most cases is dubious. One method of reducing excess spending on brand name drugs is to target physician behavior in this regard.

Prior research has shown considerable variation in physician beliefs and practices regarding generic substitution, as well as poor understanding among physicians of the FDA regulations for generic products (Banahan and Kolassa 1997; Murphy 1999). Physicians may be influenced by marketing information to believe that brand name drugs are somehow more effective or are held to a higher manufacturing standard, even in the absence of data supporting this belief. The important role of the physician in the decision to use a brand name or a generic drug has been described previously (Hellerstein 1998), and some interventions have attempted to target physician behavior directly (Ahluwalia et al.). Nevertheless, given that Medicaid already has financial regulations favoring the use of generic drugs (by limiting payment for the brand name version), this portion of potential savings may be difficult to achieve through reimbursement policy and may require additional changes in physician prescribing practices. One important limitation of our analysis was our inability to incorporate manufacturer rebates into the calculations. The rebates are calculated based on the average manufacturer's price for a drug (National Pharmaceutical Council 1998); that price is not easily available and was not practical to use as part of this analysis.

Variations in MAC price levels are also an important source of unrealized savings. The drug-by-drug analysis (Table 3) demonstrates that most potential savings come from a small number of medications. Indeed, in the main analysis, clozapine alone accounts for over 10 percent of the potential savings. The best MAC price available analysis provides evidence that some states are more successful at controlling costs for specific medications. The large increase in potential savings for some of the medications implies that much lower prices for these medications are available in some states than others. There is considerable heterogeneity among states in the proportion of drug spending which could have been saved by greater use of generic medications (Table 2). Variation in how states implement their MAC programs for prescription drug price limits may account for such differences. Future research comparing the details and operationalization of MAC programs across states may provide important information for the design of a Medicare prescription drug benefit and could help realize some of the potential savings. Policy efforts that target specific medications may be able to address areas of excess spending in an efficient manner.

There has been controversy about generic substitution for some of the drugs listed in Table 3, notably warfarin (DeCara, Croze, and Falk 1998; Wittkowsky 1998; Benson and Vance-Bryan 1998; Haines 1998) digoxin (Weintraub et al. 1979; Reissell et al. 1974; Lindenbaum et al. 1971; Jounela and Sothmann 1973), and levothyroxine (Rennie 1997; Dong et al. 1997). Newer evidence argues that generic versions of these drugs are appropriate, although increased monitoring may be required when converting from brand name to generic medication (Rennie 1997; Dong et al. 1997; Baker et al. 1988; Hendeles et al. 1995; Kanthawatana et al. 1994; Kramer 1989). The persistent controversy and potential transition costs may limit the potential savings from these three drugs.

In important ways, the data presented above represent a conservative estimate of the potential savings from more widespread use of generic drugs. By limiting the savings calculation to tablets and capsules, we assumed that there were no potential savings for inhaled medications, topical medications, transdermal patches, and several other classes of widely used drugs.

There has been much interest in more aggressive substitution of different drugs within a class (McAlister et al. 1999), (therapeutic substitution, e.g., switching one ACE inhibitor for another), and this practice is currently mandated in many private insurance plans. A recent study of a reference-pricing system under which a health plan would only pay for lower priced ACE inhibitors demonstrated cost reductions without adverse effects on patients or other health care expenditures (Schneeweiss et al. 2002). We did not attempt to incorporate this source of savings into our analysis; all potential savings described here result from the replacement of a brand name product with a generic drug of identical chemical composition and duration of action.

One important question that has been addressed in prior research (Bae 1997; Stolberg and Gerth 2000) is the pattern over time of market entry and prescribing of generic drugs after a medication goes off patent. Our research examined unrealized savings only for drugs for which generics were already in the marketplace. More information on the patterns of adoption of generic alternatives as they become available would help clarify one cause of the excess costs from use of brand name drugs described above. The rate at which physicians begin writing for generic names of drugs or stop invoking medical necessity for brand name drugs will likely correlate with the extent and effectiveness of marketing of the original brand name drugs. Further research is also needed on the causes of delays in commercial availability of generic alternatives after patents have expired on the original brand name products (Stolberg and Gerth 2000).