Demystifying FAP, R-zone and the bi-annual reimbursement rate reductions

February 2012

In April, MHLW will implement the next round of bi-annual reimbursement rate reductions. The reimbursement cuts are always a source of frustration for foreign companies. For many, the process seems to lack transparency and predictability.

To better understand the reductions, it is important to understand the key mechanisms that impact the magnitude of the cuts and the number of products affected. By understanding the mechanisms, companies can 1) better predict reimbursement price changes and 2) better manage pricing to help limit their exposure to reductions.

Price reductions are made based on two key mechanisms: the reasonable zone (R-Zone) and foreign average pricing (FAP). All products risk potential R-Zone reductions; however, only a limited number of products are subjected to and face the risk of FAP reductions.

What are R-zone reductions?

R-zone reductions are based upon the margins that distributors offer to hospitals for products in a specific functional category. The MHLW conducts a distributor pricing survey to assess the prices being charged to hospitals and the resulting margin as a percentage of the prevailing reimbursement rate. If survey results indicate that discounts exceed the allowable margin (currently 4%), reimbursement rates will be reduced to bring them back in line with the allowable margin.

The intention of the R-zone is to prevent drugs and devices from becoming a profit center for hospitals. Historically, unchecked margins resulted in over prescription and usage. As a result, the R-zone was introduced as a way to enable hospitals to cover the administrative costs of drugs and devices without allowing them to make excessive profits.

The best way to avoid R-zone reductions is to avoid price-based discounting. Companies that compete based on price should expect reimbursement rates for their products to spiral downward over time.

What are FAP reductions?

Foreign average price reductions are price reductions implemented when a product's reimbursement rate exceeds 1.5x the simple average of the list price in four reference countries ? the US, UK, France and Germany. List price data is obtained directly from manufacturers through an industry association, the AMDD. Not all products are included in the pricing survey. The product categories included in each survey are announced in advance and the number of products surveyed is always a source of contention and negotiation between the MHLW and industry.

Many companies falsely believe that their products are subjected to both R-zone and FAP cuts. In fact, FAP cuts are calculated after R-zone adjustments have been taken into consideration. As a result, the cuts are independent and not additive.

The best way to avoid FAP reductions are to 1) not be included on the list of products included in the list price survey and 2) to develop a global pricing strategy that limits a product's exposure.

A number of techniques can be used to help limit a company's exposure to reimbursement rate declines.

1. Avoid price-based competition

Price-based competition is the primary driver of R-zone reductions. As an alternative to reducing prices, companies should consider alternative means of competition such as service improvements or product enhancements. If companies are unsuccessful in doing so and can only compete based on price, they should expect to face ongoing downward price pressure. The level of reductions should be somewhat predictable as it will be reflective of the overall level of discounting that occurs in the market.

2. Pursue C1 / C2 reimbursement

Reimbursement categories often contain a variety of products with differing features and / or quality levels. As a result, premium products are sometimes unfairly lumped into reimbursement categories with more commoditized products that are more likely to be discounted. Because of the broad nature of some reimbursement categories, even those manufacturers who don't discount may be subjected to reimbursement rate reductions caused by aggressive discounting by other participants in their category.

To protect themselves from price erosion within a category, innovative manufacturers should consider pursuing their own C1 or C2 reimbursement category. By creating an independent category, the innovator reduces the number and variety of products in the reimbursement category for their product. In turn, this reduces the likelihood of price-based competition and reimbursement rate reductions.

3. Develop global pricing policies and strategies

As a result of FAP, companies must think about their product portfolios and pricing at a global level. To avoid FAP exposure, companies may wish to modify pricing levels in the reference countries and / or offer a different product mix in each country.

FAP has received a significant amount of press and is often the subject of industry frustration; however, in recent years, R-zone has become a much more significant threat to reimbursement in Japan. The calculation methods used for both mechanisms are fairly clear and transparent. With a little planning, companies can better predict and protect themselves from reductions. Because both mechanisms are dependent in part on the manufacturer's own pricing, the magnitude of reductions should be relatively predictable assuming the mechanisms for reduction are well understood and the manufacturer has an understanding of the pricing dynamics in their product categories.

NOTE: For more information on Japan's reimbursement system, click here.

Click here for additional Healthcare articles