The Buying Group Paid by the Companies It Negotiates Against

Aggregating Demand Is Genuinely Useful

A single hospital that purchases gloves sutures implants and imaging equipment negotiates alone with manufacturers much larger than it. A thousand hospitals that purchase together have influence

Group purchasing organizations They exist to provide that aggregation. They negotiate contracts with suppliers on behalf of member hospitals who can then purchase on the negotiated terms without conducting their own negotiations

The value is real. Members avoid the cost of negotiating thousands of contracts get prices that reflect collective volume and receive contracting expertise that a small hospital could not employ. Estimates of the share of hospital supply spending that flows through these agreements exceed two-thirds

Who Pays for It

The funding model is the point of contention and is unusual enough to be stated clearly

These organizations are mainly funded by administrative fees Paid by the providers whose contracts they award usually calculated as a percentage of the value of products sold through the contract. Typically a portion is shared with member hospitals

Therefore the organization that negotiates prices down receives compensation as a percentage of the amount its members spend from the party selling to them

A Worked Example: What the Fee Structure Actually Rewards

The notice above describes the conflict qualitatively. Attaching numbers shows how poorly proportioned the incentives are which is the part that makes this more than a theoretical objection

Set up the organization. One purchasing group has $50 billion of member spending flowing through its contracts and charges suppliers a 3 percent administrative fee the maximum level of the safe harbor described below. Its commission income is $1.5 billion

Now let's assume that it does its job extremely well. and negotiates prices down 10 percent across the board.Member spending drops to $45 billion.Fee is a percentage of spending so fee revenue falls to $1.35 billion

The organization just saved its members $5 billion and reduced its own revenue by $150 million

Now run it in the other direction. Suppose you agree to terms 5 percent higher than you could have achieved perhaps by agreeing to a joint contract that is convenient to administer. Member spending increases to $52.5 billion. Commission income is $1.575 billion a profit of $75 million

Read the bottom row. The organization makes $75 million in a scenario where its members pay $2.5 billion more. The ratio is approximately 33 to 1 relative to the people it works for

The shared fee returned to members softens this problem and does not solve it. Let's assume that 70 percent of the dues revenue is returned to members. In the higher price scenario they will receive about 1.10 billion instead of 1.05 billion a profit of about $52 million versus $2.5 billion in additional spending. The ratio improves from 33 to 1 to about 48 to 1 against them because participation flows through the same percentage of a larger number

That is the structural point and it does not require anyone to behave badly. Each party can act in good faith and the compensation still points in the wrong direction because a percentage of the expense is a percentage of the expense

It is worth being precise about what this proves and what it does not. It does not show that these organizations get higher prices and there is real evidence that they save their members money compared to negotiating alone. It shows that the mechanism that disciplines them has to be competition for members and reputation because the fee structure itself provides no discipline and slightly opposes it

These are illustrative figures using round numbers and a rate at the top of the allowable range. The direction of the incentive does not depend on the specific values

The Legal Foundation

The deal would normally raise serious questions under the health care anti-kickback law which prohibits remuneration in exchange for referrals or purchases of items reimbursed by federal health care programs

A payment from a supplier to an entity that directs purchases to that supplier is precisely what the statute addresses. The practice exists because the 1986 legislation created a legal exception and the regulations established a safe harbor for group purchasing agreements that meet specific conditions including a written agreement disclosure of fees to members and a fee equal to or less than three percent or full disclosure of the amount

Therefore the industry as it exists is the creation of a specific legislative choice not an outcome that general law would have allowed

The Criticisms

Three arguments are repeated and each one has some evidentiary basis

Exclusion of innovation. A small manufacturer with a better product must get a contract to reach hospitals and contracts are typically long-term single-source or bundled across product categories. In particular bundling where favorable prices in one category are conditional on purchasing others can make it impossible for a single competing product to compete on its merits. Senate investigations in the early 2000s examined exactly this and produced code of conduct commitments for the industry

Concentration. A small number of organizations represent the vast majority of hospital purchasing meaning that a supplier excluded from those contracts is effectively excluded from the market

Supply chain fragility. Contracts awarded on the basis of price to a small number of suppliers concentrate production and shortages of generic injectable drugs and basic supplies have been attributed in part to purchasing practices that reduced margins to the point that manufacturers quit or underinvested in capacity. When a single plant produces most of the national supply of a common saline solution or generic a single outage becomes a national shortage

Case Study: The Saline Shortage and the Hospitals That Built a Factory

The fragility argument sounds abstract until a hurricane demonstrates it as happened in September 2017

The scarcity. Intravenous saline is the most basic hospital product there is: sterile salt water in a bag used for hydration and administering medications. It is also extremely cheap which over years of price-based contracting had concentrated its production in a small number of facilities operated by a small number of manufacturers

A large portion of U.S. production of small-volume saline bags was done in Puerto Rico. Hurricane Maria hit the island in September 2017 damaging facilities and knocking out power for an extended period. The result was a national shortage of a product that costs about a dollar

Hospitals rationed. Doctors administered medications manually rather than by infusion. Elective procedures were rescheduled. Regulators authorized emergency imports. The disruption went on for months and was not caused by any drug or product failure but by the fact that a product had been optimized to the point that almost no one was making it

Trace that through the arithmetic in this article and the mechanism is visible. Aggressive price competition on a commodity drives the margin toward zero. With zero margin manufacturers abandon or refuse to invest in redundant capacity because redundant capacity has to generate returns. What is left is the lowest-cost producer concentrated in the fewest possible plants which is precisely the configuration that fails catastrophically in the face of a single event

The answer. In September 2018 a group of major health systems along with philanthropic sponsors founded Civica Rx a nonprofit generic pharmaceutical manufacturer. Its explicit purpose was to produce drugs that were persistently in short supply at predictable prices under long-term commitments from the hospitals that would use them

Read what that decision really says. A group of hospitals concluded that the purchasing system they collectively owned and financed could not offer a reliable supply of essential drugs and that the cheapest solution available was to build a drug manufacturer themselves. Since then Civica has supplied dozens of drugs to hundreds of hospitals and expanded into other categories prone to shortages

That is the most substantial criticism of the model and it is not rhetorical. It is a capital allocation decision made with real money by the people best placed to judge and the verdict it embodies is that price is not the only thing worth hiring for

The Defence

The industry response is substantial and worth mentioning

Members choose to participate and can contract directly whenever they prefer and many do so for high-value items preferred by doctors such as implants. Fee disclosure is required. And independent analyzes have found significant savings relative to what individual hospitals would achieve on their own

The contradiction to the incentives argument is that members would leave if prices were not competitive and that competition among purchasing organizations disciplines the outcome

That defense is strongest for raw material supplies where prices are comparable and members can verify performance and weakest for categories where price transparency is poor

Where the Critique Overreaches

The conflict of interest argument is strong and outweighed in four ways

Several of the largest organizations are owned by their members. When hospitals collectively own the purchasing entity the conflict is substantially internalized: fee revenues that appear to be leakage return to the same balance sheets through ownership and also through fee participation. That does not eliminate the misalignment described in the example worked and makes the framing of an adversary extracting rents from its own members considerably less appropriate

The shortage has many causes and the purchasing model is one of them. Contributing are the concentration of active pharmaceutical ingredient production in a small number of countries manufacturing quality failures that close plants for regulatory reasons and reimbursement rules that limit what generics can earn. Attributing the shortages primarily to group purchasing is an overreach although price-based contracting is a genuine part of the picture

Savings studies are financed by interested parties in both directions. Industry-commissioned analyzes find large savings and critics-commissioned analyzes find the opposite. There is no neutral well-identified estimate of what hospital supply costs would be without these agreements and anyone who cites a precise savings figure is citing an advocate

Eliminating the safe harbor would hurt small hospitals the most. A large health system can employ its own contract staff. A two-hundred-bed rural hospital cannot and it is to the member for whom the aggregation function is most valuable. Reform that increased the cost of the model would fall most heavily on exactly the institutions least able to replace it

My view is that the funding model is truly indefensible by design and that the practical harm is manifested in resilience rather than price which is why the response has been for hospitals to increase supply rather than abandon it

What Changed Recently

Shortages during and after the pandemic attracted renewed attention and several developments occurred

Some large health systems formed their own purchasing entities or invested directly in manufacturing capacity notably a nonprofit generic drug manufacturer created by a group of hospital systems specifically to address products prone to shortages. This was an explicit judgment that the existing purchasing model did not create supply reliability

Procurement practice has also shifted towards including supply assurance commitments and dual sourcing requirements rather than awarding solely on the basis of price directly addressing criticism of fragility by accepting a higher price for resilience

The Bottom Line

Group purchasing generates genuine savings by aggregating demand that would otherwise be fragmented across thousands of hospitals and is funded by the suppliers with whom they deal under a specific legal exception without which they would be illegal

The arithmetic shows how disproportionate the incentives are. On $50 billion of member spending with a 3 percent fee negotiating 10 percent lower prices saves members $5 billion and costs the organization $150 million in revenue. Accepting 5 percent higher prices costs members $2.5 billion and earns the organization $75 million a ratio of about 33 to 1.against them improving only to about 48 to 1 once the odds share is counted

The conflict is structural rather than hypothetical and the strongest evidence of its cost is not in prices but in the reliability of supply. Hurricane Maria produced a national shortage of saline solution in 2017 because a one-dollar product had been optimized in a handful of plants and in 2018 a group of health systems responded by founding their own generic manufacturer. When buyers conclude that the cheapest solution is to build the factory themselves that is a verdict on the purchasing model rather than theclimate