The U.S. federal government has always had some focus on the nation’s supply chain, particularly as it relates to national security and the protection of intellectual property (IP). There have long been requirements for companies that contract with the federal government to ensure that counterfeit equipment is not being delivered to the government. Recent legislation (Section 889 of the 2019 National Defense Authorization Act) impacts all companies that contract directly with the U.S. federal government, requiring them to certify that they don’t use banned information and communications technology produced by several Chinese companies in essentially any part of their operations.
The COVID-19 pandemic has brought to light a number of additional concerns related to the nation’s supply chain across industries that have not been at the forefront of the congressional agenda. What has perhaps garnered the most attention during the pandemic are the healthcare and life sciences industries, and our nation’s ability to access drugs, medical devices and personal protective equipment (PPE).
In 2019 alone, the U.S. imported over $20 billion dollars of pharmaceuticals, medical equipment, and products and related supplies with close to $2 billion of pharmaceuticals and antibiotics coming from China. Following the outbreak of COVID-19, China closed off its exports of crucial medical equipment to the world economy and directed all production for domestic use. This pivot exposed the limited domestic stockpile in the U.S., sparking fear that drumming up that stockpile could be costly and time consuming, outpaced by the spread of COVID-19.
2020 government actions and legislation
The Department of Defense (DoD) established a Joint Acquisition Task Force (JATF) in response to COVID-19 with a mission to combat such fear. The mission of the JATF has evolved to include assisting the replenishment of the Strategic National Stockpile through the expansion of U.S. manufacturing capabilities related to drugs, medical devices and PPE. To achieve this mission, the JATF has announced a Commercial Solution Opening (CSO) solicitation for four mission-focused areas: masks, fibers and materials; screening and diagnostics; gloves and gowns; and pharmaceuticals. While the CSO closed on Aug. 3, 2020, the JATF is now undergoing review and anticipates award of FAR Part 12 or Other Transaction Authority (OTA) contracts to some companies that provided a technical merit solution brief.
From a broad federal procurement perspective, we have seen a number of executive orders, regulations and legislation put in place to help to protect the supply chain in areas aligned with the government’s main focus: national security and IP. Although these target certain industries, these directives are likely to have broad-reaching impacts throughout the U.S. and the global economy at large. Before the pandemic, there was talk of onshoring or nearshoring, and discussion within Congress and elsewhere in our federal government that focused specifically on the pharmaceutical supply chain. The pandemic appears to have sharpened our leaders’ focus on these issues, as evidenced by a spate of recent legislative activity:
Directs the U.S. Department of Health & Human Services (HHS) to develop a report that identifies gaps in U.S. domestic pharmaceutical manufacturing capabilities as well as current dependence on China for critical active pharmaceutical ingredients (API)
Requires FDA to track APIs and country-of-origin; provides incentives for onshoring; requires a waiver process for procurement of drugs by HHS, the Department of Veterans Affairs (VA) and other federal healthcare programs whose sole source of API is China
Establishes a Center for Domestic Advanced Manufacturing of Critical Drugs and Devices, responsible for assisting with investments in manufacturing for critical drugs and devices
Requires disclosure to the FDA within five days of any identified supply and demand issues, and quarterly data on production of drugs and devices for domestic versus international use
Amends the tax code to provide incentives for onshoring
There is one particular piece of legislation that the industry is anxiously awaiting: the National Defense Authorization Act (NDAA) for fiscal year 2021. A draft version of the House NDAA has been shared with the public and included in Section 712 is a commissioned report to identify weak points in the pharmaceutical and medical device supply chain. The industry is waiting to see if the NDAA ultimately goes beyond a report and hones in on any specific onshoring efforts.
In addition to the bills presented in the House and Senate throughout 2020, the executive branch has been pushing a complementary agenda, solidifying onshoring at the forefront of federal government attention. On March 18, 2020, former President Trump issued Executive Order 13909, invoking the Defense Production Act (DPA) in response to COVID-19. The DPA allows the former president to build up the defense industrial base in response to a public health emergency.
On May 14, 2020, former President Trump issued an executive order delegating authority to the U.S. International Development Finance Corporation (DFC), an executive agency development bank, to issue loans to bolster the domestic supply chain for items needed to respond to the pandemic. Although the bank is small, Chief Executive Adam Boehler noted there will be dedicated individuals focused on domestic onshoring. In June 2020, the DFC signed a joint memorandum with the DoD to focus $100 million in loans on assisting with the onshoring effort, highlighting collaboration between the two agencies.
On Aug. 6, 2020, former President Trump issued an executive order addressing U.S. manufacturing of essential medicines and critical inputs. This directly addresses onshoring efforts to reduce the country’s dependence on foreign supply chains. Former President Trump wanted to accelerate the development of cost-effective and efficient domestic production and to maintain such production of critical inputs, finished drug products and finished devices for the American public. Within are provisions calling on the development and implementation of long-term contracts within 90 days of the order to increase domestic manufacturing.
Effects on pricing
Despite this focus from Congress and the executive branch, tax incentives and other funding that may be available, moving manufacturing back to the U.S. is likely to require significant effort by manufacturers and significant internal investment to build new facilities. Although the tax relief measures and forgivable loans, like the ones noted in S. 3780, will help in alleviating some of the costs associated with onshoring, we wonder if it will be sufficient to defray all the short-term and long-term costs associated with relocating manufacturing facilities. At least in some cases, it is likely that these increased costs will trickle down into the prices paid by consumers and by the government, either through the prices paid under the Medicare and Medicaid programs, or under the contracts the federal government enters into to purchase drugs and devices for the DoD, the VA and other agencies.
What we do not see in the legislation presented thus far are any significant measures to address the potential for increased prices, which is somewhat surprising, given the recent focus on drug pricing. HR 5982 contains provisions for measuring the impact on domestic drug prices should there be a disruption of the export of drugs from China, but it does not address how to handle such an impact should it arise.
While the pricing in the commercial market for pharmaceuticals and medical devices is largely up to the manufacturer and the competitive landscape and agreements negotiated with payers, the pricing for federal procurement of medical devices and pharmaceuticals is strictly controlled by regulation. While there are many programs and nuances associated with the regulations governing these programs, we are providing a few examples in the paragraphs that follow.
Price regulation via government programs
Through the Medicaid Drug Rebate Program (MDRP), drug manufacturers pay a rebate to states on drug purchased through Medicaid plans. At its core, the two key elements of this rebate calculation are average manufacturer price (AMP), which is the average price paid by wholesalers for drugs distributed to the retail class of trade, and best price (BP), which is the lowest price available from the manufacturer during the rebate period. Depending on the type of drug, basic rebates fall between a 13% and 23.1% rebate off of the AMP, or the difference between AMP and BP.[1] However, the calculations performed to determine the rebate amount include a price penalty for price increases that outpace inflation. If the costs associated with onshoring or nearshoring of manufacturing capabilities lead to significant price increases, a manufacturer’s ability to recover costs through increased prices could be capped under the current Medicaid program.
Drugs are most frequently sold to our nation’s veterans through the 65IB VA Federal Supply Schedule (FSS). On FSS contracts, innovator and single source drugs are made available to the VA, DoD, PHS and Coast Guard at capped statutory prices or the Federal Ceiling Price (FCP). The FCP price is a function of the Non-Federal Average Manufacturer Price (NFAMP) or the price paid by wholesalers to the manufacturer.[2] Similar to the Medicaid program, the laws that govern these contracts have a mechanism in place to keep price increases relatively small year-over-year, known in industry as the price penalty.
Should the prices paid by non-federal customers increase drastically to cover the costs of onshoring, this penalty will cap the FCP and the manufacturer’s ability to recover cost on the VA FSS. Generic drugs can also be sold through FSS contracts, which can open up a new market for manufacturers, but can also create unique pricing and compliance challenges. If this is viewed as an important market, onshoring could provide some benefit, as it may allow companies to sell into this market while remaining in compliance with the Trade Agreements Act, which places restrictions on where products being sold to the federal government can be manufactured.
The federal government procures drugs, medical devices and supplies under a variety of different contracts and programs, including the VA FSS program, MDRP, DoD’s ECAT program, Medical Surgical Prime Vendor Program (MSPV) and others. Manufacturers need to be aware of their pricing requirements under the various programs and understand how increased costs associated with any onshoring or nearshoring efforts could impact their ability to perform and deliver their products under these programs. Many of these contracts have specific pricing requirements and some restrictions and processes to follow to affect a price increase. Manufacturers who are considering changes to their supply chains need to understand these requirements and factor them into their decision-making process, and to ensure that any steps that need to be taken along the way related to pricing, contracting or other activities, are addressed at the appropriate time.
Conclusion
With supply chain continuity and resiliency for pharmaceuticals and medical devices at the top of the legislative agenda, it is likely we will see more laws in the coming months that address the supply chain, and specifically onshoring efforts. We expect these efforts will have an impact on pricing down the line, and hope to see future legislation that considers the cost of these efforts.
Manufacturers of drugs, devices and supplies should consider all of this in their decision-making when it comes to examining and potentially making changes to their supply chains. In our experience working with companies to understand their supply chains and focus on optimization, security, continuity and resiliency, there are a number of complex issues to consider and address. Add in regulatory and legislative factors, and making wise decisions related to a company’s supply chain can be very daunting.
Starting with a broad view that considers third-party and fourth-party risk management can help to identify risks and support strategic decision-making. After taking a broad view, the development of a plan that considers the wide array of factors that can impact and influence decisions and the actions that need to be taken along the way to mitigate risks and accomplish goals is very important. In the current environment, companies who are out in front on this may not only be well positioned to mitigate risks, they may also find that they have developed a competitive advantage and differentiator in the U.S. market.
For more information on this topic, or to learn how Baker Tilly specialists can help – please contact Jeff Clayton or Elizabeth Bair.
[1] This is a simplification of the calculations necessary to determine the Unit Rebate Amount (URA) that manufacturers pay under the MDRP, which can be highly nuanced and vary dependent upon a number of factors.
[2] This is a simplification of the NFAMP and FCP calculations required for covered drugs sold under the FSS program. The actual calculations are highly nuanced, require the inclusion and allow for the exclusion of certain transactions, and can vary dependent upon a number of factors.
