Anyone who thinks that the new prescription drug benefit plan (the Medicare Modernization Act) signed by President Bush will have anything resembling predictable expenses needs to pay attention to what's going on in Pennsylvania. The commonwealth filed suit yesterday against 13 large drug companies, accusing them of price manipulation.

Essentially, Pennsylvania says that the companies have multiple prices -- one that they charge physicians and the "average wholesale price," which is what the medical providers can then bill the government, insurance providers, and patients at the much higher "average retail price." Named in the lawsuit are Pfizer (NYSE:PFE), AstraZeneca (NYSE:AZN), Amgen (NASDAQ:AMGN), Bristol-Myers Squibb (NYSE:BMY), Schering-Plough (NYSE:SGP), GlaxoSmithKline (NYSE:GSK), Bayer (NYSE:BAY), TAP Pharmaceuticals, Boehringer Ingelheim, Johnson & Johnson (NYSE:JNJ), Baxter (NYSE:BAX), Dey Pharmaceuticals, and Aventis (NYSE:AVE).

Pennsylvania claims that this scheme entices the medical providers to engage in negative price competition, where they have incentive to prescribe not the most cost-effective treatment available, but the most expensive one, since they get to pocket the difference.

The existence of a tiered pricing system for drugs, though, ought to surprise no one; in fact, third-party pricing systems exist to track what the companies are charging. Pricing variability is how the identical drugs imported from Canada, for example, are cheaper than they are buying them in the United States. But it has been standard practice for years for drug companies to offer a list price, but then provide drugs at substantially reduced prices to list. This happens in almost every business. What Pennsylvania is charging is that the prices for these drugs were artificially inflated, and it seeks relief and rebates going back to 1991. Specifically, that the 13 companies "oppose[d] and avoid[ed] efforts to reduce prescription drug costs and/or to change the way in which payors reimburse for prescription drugs, and ... act[ed] to conceal and suppress their conduct to prevent detection by others."

That's 13 years worth of money that Pennsylvania wants repaid. It's also a pretty strong indictment not of the drug companies themselves, but of the flab that inevitably builds in third-party payer systems. When the government steps in to provide service, it does not have the price sensitivity that an individual payer would. Take, for example, this post from a doctor on the Fool discussion boards on when he started practicing in the 1960s:

Medicare was started in the 1960s and basically said "we'll give you 80% of what you charge for procedure X." It didn't take very long for doctors to figure out that an appendectomy costing $100 got them $80 but an [appendectomy] that you charged $1000 for got you $800 and you could often forgive the other $200 the patient was on the hook for....

Perhaps there's something to the belief that drug companies are overcharging, so the Pennsylvania case will have to be determined on those merits. But watch closely what happens here. Pennsylvania may successfully win the suit and generate some rebates for the state and insurance companies as well as patients. Somehow, though, we have a problem that has gone on for at least 13 years without the state bringing action -- something that would never happen if the free market were allowed to work.

Drug prices aren't going down, and even if they did, it wouldn't have anything to do with drug costs. Why should they?

Bill Mann owns none of the companies mentioned in this article.