On October 14, to much fanfare, the Chinese government released a highly anticipated blueprint for reforming the country’s health care system. The proposal has been opened for public review, drawing a keen response from China’s netizens.


    No wonder. It is the government’s latest and — in theory — most ambitious attempt to deal with rising medical costs for Chinese consumers. One of the most controversial issues at stake is drug pricing: What is the prognosis for more affordable drugs in light of the reform proposals? Much depends on how regulators address problems in hospital funding and doctors’ pay, a fragmented drug distribution system, and an immature medical insurance architecture, experts say.


Systemic Ailments


    Understanding why China’s regulators want to reform drug prices, and the challenges involved, requires a brief grounding in the broader context of the health system.


    Until the 1980s, the government paid for everyone’s health care costs. However, after the launch of China’s economic reforms, the state withdrew from public health care funding and by 2007 contributed only 7% of total hospital revenues. Given low public funding, hospitals turned to the other two main options for generating income: medical services and drugs sales. But for hospitals struggling to turn a profit (on average, public hospitals profit just US$240,000 annually), providing medical services has been a financial burden: Based on these services alone, public hospitals lost US$620,000 on average in 2007. To survive, they had little choice but to rely heavily on drugs sales, which accounted for 42% of revenues in 2007.


    These skewed incentives have had a sizeable effect on China’s pharmaceuticals industry, since hospitals account for 80% of China’s drug market.


    “The situation for public hospitals in China is very hard,” says the head of a third grade hospital (the highest rank under China’s hospital classification system), speaking on condition of anonymity. “The government’s funding is very limited, and the medical service prices were set 10 years ago and haven’t been raised.” The result is that medical service charges in hospitals do not reflect labor costs. An appendectomy, for example, costs at most RMB 200 – cheaper than a hair salon visit, he points out. “So it is not hard to understand why hospitals rely too much on the sales of drugs, and hospitals have incentives to prescribe more drugs to patients.”


    Individual doctors’ incentives are similarly distorted. Surveys show that Chinese doctors are overwhelmingly unhappy with their salaries. One recent survey of over 2,000 physicians revealed that three quarters earned less than RMB 3,300 (US$480) per month. Their remuneration commonly depends on bonuses awarded for growing hospital revenues. This can lead to over-prescribing for profit: In one study, 98% of outpatients with a common cold were found to have been prescribed antibiotics.


    Drug makers also helping to push up drug prices. “Prices paid to pharmaceutical manufacturers are principally based on manufacturers’ self-reported production costs,” according to Sun Qiang of Shandong University and his co-authors in a paper titled, “Pharmaceutical Policy in China,” published this summer in the journal Health Affairs. “Manufacturers have incentives to inflate self-reported costs to increase both their own margins and those of their primary customers — hospitals. This sequence of incentives contributes to shortages of low-price medicines.”


    Speaking at this year’s China Health Care Management Forum in Guangzhou, Zhu Dezheng, an official from the National Development and Reform Commission’s (NDRC) pharmaceutical pricing division, explained how all this translates into the price paid for a bottle of pills. A manufacturer might typically expect to receive about 30% of the final consumer price for a drug. A drug typically also passes through multiple tiers of distributors, where it undergoes additional markups. So, China’s fragmentary drug distribution system claims a further 20%-25% of the final sale price, Zhu reckons.


    “Hospitals are taking the largest share of the pie,” he says, estimating that of the 45%-50% of the total end price collected by hospitals, 30% represents their markup (despite an official government cap of 15% on hospital markups). “The other 20% goes to a grey sector to encourage hospitals and doctors to prescribe drugs.”


    According to Li Fengxia, a senior sales rep at one of the domestic pharmaceutical industry leaders, pharmaceutical companies in China almost all spend heavily on kickbacks and other forms of inducement to boost drugs sales to hospitals. “The cost finally goes to the consumer,” she says.


Strained Patients


    The perception that drugs are expensive is widespread in China. Despite this, Sun and his co-authors note that researchers’ attempts to measure how drug prices in China compare to international norms have yielded mixed results. One recent government study comparing pharmaceutical price levels in China to those in 16 other countries found Chinese prices were at the lower end. By contrast, a 2004 survey of prices in Shandong province concluded that while generic drug prices were roughly equivalent to international norms, brand drug prices were far higher.


    But the high level of public dissatisfaction over drug prices is beyond dispute. Recent official surveys and internet polls suggest that medical costs are one of the top causes of public concern.


    It is clear that drug prices have a significant impact on overall consumer medical spending, which is rising in GDP terms. Drugs account for 50% of total spending by outpatients and 43% for inpatients. Meanwhile, overall health care spending has been rising faster than GDP since 1978, as Du Lexun of Harbin Medical University explains. The brunt of this has overwhelmingly been borne by individuals. By Du’s calculation, while health care spending grew 60-fold between 1978 and 2005, government spending merely doubled.


    The underdeveloped nature of China’s medical insurance system heightens individual health care burden. “Despite recent efforts to expand social insurance programs, coverage remains limited,” according to Sun and his co-authors. China has three basic health insurance systems. Only 27% of urban residents are covered by Urban Employee Medical Insurance, introduced in 1999. Moreover, Sun and his fellow authors say that it is too soon to predict the success of a new pilot insurance program for city dwellers, Urban Resident Medical Insurance. Launched in the latter half of 2007, this targets non-employed urbanites with the emphasis on school children and the elderly. The New Rural Cooperative Medical Scheme (NRCMS), meanwhile, covered 86% of the total rural population by September 2007. However, the Sun and his co-authors say the NRCMS’s benefits are “modest, and patients continue to bear large out-of-pocket spending amounts”.


    Increasing the availability of affordable drugs has thus become a key priority. The NDRC has implemented 24 rounds of nationwide price cuts, claiming to have saved individuals over RMB 50 billion (US$7.32 billion). At present, roughly 60% of pharmaceutical sales in China are subject to price regulation and centralized drug procurement through a bidding process at the provincial level.


    Yet results have been disappointing. Ask Mrs. Li, a long-term diabetes patient from Shandong province. “I don’t feel my medical expenses are getting lower,” she complains. “It is becoming more and more difficult to get cheap drugs in hospitals now, and doctors are more inclined to recommend new drugs, or drugs produced by multinational pharmaceutical companies, which turn out to be more expensive.”


    “Regulated price decreases appear to have had limited effect in controlling health spending growth,” according to Sun and his co-authors, and they have even had negative side-effects — such as exacerbating drug shortages. Moreover, there is little evidence that bidding has spurred competition, they say. “Clearly, China’s drug pricing reform … should be implemented in coordination with other health system reforms, especially in hospital finance and expansion of health insurance coverage.”


Attacking the Causes


    To date, it appears the regulators have been attacking the symptoms but not the root causes of the problems in China’s medical system. On paper, the government’s reform proposals set out to correct this. They announced an intention to provide more than just symptomatic relief in the three critical areas influencing the affordability of drugs: hospital financing, medical insurance and the pharmaceutical distribution system.


    Taking aim at the skewed incentive system for public hospitals and doctors, the plan envisages returning hospitals to non-profit status. It cites subsidies for public hospitals, with all revenues being channeled to the state, and augmenting doctors’ pay via a prescription fee on a trial basis.


    The draft also states a clear target for medical insurance: to cover 90% of the population by 2010, with universal health care by the end of the next decade — all in line with the people-centered, primary health care model advocated by the World Health organization, as Dr. Sarah Barber of the WHO in Beijing points out.


    The draft of reforms also incorporates a proposal by foreign invested pharmaceutical companies to overturn the current uniform 15% markup imposed on hospitals in favor of differentiated pricing on a trial basis. More expensive drugs would be subject to lower markups, and vice versa.


    Moreover, a pilot labeling scheme on essential medicines could, if effective, help limit distributor markups and inject economies of scale into the distribution network. Whatever the debate over other details of the reform, Dr. Barber believes that a consensus exists on essential drugs, a priority area for the WHO. (According to the WHO, these are drugs that “satisfy the priority health care needs of the population …  intended to be available within the context of functioning health systems at all times in adequate amounts, in the appropriate dosage forms, with assured quality, and at a price the individual and the community can afford.”)


    Like many countries, China already has a national list of essential drugs. But, as the reform proposal implicitly acknowledges, the problem is one of access and affordability. Under the current draft of the plan, by 2010 80% of local medical institutions would gain easy access to reasonably priced essential drugs. Meanwhile, a system of medical insurance reimbursements for essential medicines is to be implemented. In sum, Dr. Barber believes China’s regulators are now on the right track regarding essential medicines.


    What’s more, in an innovation some believe could have wide-ranging implications for distributor markups, the proposal calls for essential drug prices to be printed on the outer package. A number of pilot programs have already attempted to shrink distribution markups, with varying effectiveness. Guangdong, for instance, has pioneered a “sunshine online bidding” system to increase the transparency of centralized drug purchases. This has forced drug makers to cut the price of drugs by about 20% before they reach hospitals. Jiangsu province, meanwhile, has experimented with allowing the province’s biggest distributor to manage pharmacies in over 80 hospitals. This has been less successful: Distributors and hospitals reached an agreement whereby the former passed on 40% of their revenues to hospitals in fees.


    However, Li Lei, director of China Pharmaceuticals Enterprise Competitiveness Project (a non-government organization that researches industry competitiveness), thinks the new labeling proposal will have a significant impact on industry distribution. Li, a central government adviser involved in producing a set of detailed supporting documents to accompany the reform proposals, says that although the innovation will be piloted with essential drugs, within a relatively short time it will be rolled out across the board. He expects small scale distributors to be squeezed out of the market as diseconomies of scale start to bite.


    “Indirectly, the policy will also affect small- and medium-sized pharmaceutical manufacturers,” he adds. In the past, these smaller pharma companies relied on regionally based distributors to sell their drugs. Now they must to turn to larger distributors, and if their products are not up to scratch distributors will be reluctant to carry them. In theory, this should all result in further economies of scale, putting downward pressure on prices.


Reform: What the Doctor Ordered?


    Nonetheless, many Chinese academics and other commentators have been highly critical of the plan. The announcement of the reform proposal has been a long time in the making, with debates reportedly centering on whether the increased government funding should be funneled into improving the medical insurance system or funding hospitals. Both ideas are present in the document, leading to fear that the institutional gridlock has not been resolved, and that reforms have been watered down.


    The document carries few details, and does not explain, for example, how the government would finance hospitals if they are transformed back into non-profit institutions. Neither does the proposal set specific targets for government spending, merely calling for a gradual increase in government spending to reduce the reliance on out-of-pocket payments by patients. What about concrete changes to doctors’ pay structure? Gordon Liu, an economist at Peking University’s Guanghua School of Management told The Wall Street Journal the plan is “hard for experts to understand.”


    But the WHO’s Dr. Barber adds that systemic reform is inevitably a long-term undertaking. “This reform document is a blueprint for a pilot, not a full-country roll-out,” according to Lewis Husain, an independent health care analyst. “It’s potentially interesting as a way to gauge the official line, but that it’s a long way from actually having an effect.” Once further input has been incorporated, more trials will be launched, which will then be subjected to further assessment and refinement of any reforms. “The point being that impact – at this stage anyway – is probably quite limited,” says Husain.


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