Pharmacy Benefit Design: PBM Relationships, Formulary Strategy, and the Small Group Disadvantage

Small group level funded plans face a structural pharmacy disadvantage. The three dominant PBMs, CVS Caremark, Express Scripts, and OptumRx, control approximately 80 percent of pharmacy benefit administration. A small group level funded plan accesses one of these PBMs through the TPA’s existing contract or through a standalone arrangement. The contract terms for a 25 person group reflect the group’s lack of negotiating leverage: spread pricing, limited rebate pass through, and formulary decisions optimized for PBM revenue rather than plan cost. Pharmacy benefit design is the benefits architecture component with the largest gap between current practice and available improvement.

The PBM Relationship for Small Group Level Funded

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The PBM serves as an intermediary between the health plan, pharmacies, and pharmaceutical manufacturers. The PBM negotiates drug contracts and pricing with pharmacies, manages the prescription drug formulary, processes claims, and in theory works to secure the lowest possible drug prices for the plan sponsor. In practice, the traditional PBM model creates misaligned incentives that work against small employers.

The contract terms for a small group reveal the structural disadvantage.

Spread pricing allows the PBM to pay the pharmacy one price and charge the plan a higher price, keeping the difference. The spread is opaque in most traditional PBM contracts. The plan cannot see what the pharmacy was actually paid. The PBM is incentivized to maximize the spread, which means charging employers more than necessary for medications. Research from SmithRx notes that in spread pricing models, PBMs can charge health plans more for drugs than they pay pharmacies, pocketing the difference, and the model incentivizes driving up the cost of drugs to capture a larger margin.

Rebate pass through is minimal or absent for small groups. Drug manufacturers pay rebates to PBMs for preferred formulary placement. In large group and jumbo contracts, a portion of these rebates passes through to the plan. In small group contracts, the PBM typically retains most or all rebates. The rebate arrangement also distorts formulary design: a brand name drug with a higher rebate may be preferred over a lower cost generic or biosimilar because the PBM’s revenue is higher, even though the plan’s cost is higher.

Formulary design reflects the PBM’s rebate arrangements rather than the plan’s clinical needs. The PBM’s formulary is designed for its entire book of business, optimized for rebate revenue across millions of lives. The formulary may not serve the specific drug needs of a 25 person population. A member who needs a specific medication that is not on the preferred formulary faces higher cost sharing or prior authorization barriers designed for the PBM’s aggregate economics.

Specialty drug management is particularly problematic. Specialty drugs, those costing more than $1,000 per month, represent more than 50 percent of pharmacy spending for many plans. The PBM’s specialty pharmacy is often a captive subsidiary that charges the plan higher prices. The cost drivers from Series 09, including GLP-1 medications, biosimilars, and gene therapies, hit small groups hardest because they lack the volume to negotiate manufacturer discounts.

The Specific Disadvantages at Small Group Scale

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The 25 person group represents negligible volume to a large PBM. Contract terms are standard. Negotiation on spread, rebate pass through, or formulary design is not available in the way it would be for a 5,000 person employer.

Lack of transparency compounds the volume disadvantage. The plan sponsor often cannot determine the actual cost the PBM pays for medications, the rebate amounts retained, or the spread on individual prescriptions. The Consolidated Appropriations Act gag clause provisions prohibit contractual restrictions on this information, but enforcement is developing and many PBM contracts have not been updated to reflect the new requirements.

The pharmacy spend trajectory makes this structural disadvantage increasingly costly. Employer pharmacy costs rose 7.7 percent in 2024 following an 8.4 percent increase in 2023. Pharmacy is the fastest growing component of health benefit costs. A small employer absorbing these increases through a traditional PBM arrangement with spread pricing and retained rebates is paying more than necessary for an expense category that is growing faster than any other.

Alternative Pharmacy Models

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Transparent PBMs offer a different structure. Capital Rx, SmithRx, Rightway, and other transparent PBM models use pass through pricing with no spread, disclose rebate handling, and charge the plan an administrative fee rather than retaining margin on drug pricing. SmithRx reports that its book of business performs around $70 per member per month in pharmacy benefit spend, including administrative fees, which it claims is 40 percent lower than industry benchmarks. Capital Rx uses National Average Drug Acquisition Cost as a public pricing benchmark, providing visibility into actual drug costs.

The value proposition of transparent PBMs is clear: pass through pricing eliminates the spread, 100 percent rebate pass through returns manufacturer payments to the plan, and flat administrative fees replace the opaque margin structure. SmithRx reports reducing pharmacy benefit costs by an average of 30 percent and saving clients an average of $25 per member per month using its suite of cost saving programs.

The question for small groups is whether transparent PBMs serve employers as small as 25 lives and whether the transparent pricing produces meaningful savings at that scale. Both Capital Rx and SmithRx serve employers across a range of sizes, including smaller groups. The savings percentage may be similar regardless of group size because the structural advantage comes from eliminating spread and passing through rebates rather than from negotiating leverage.

Pharmacy benefit coalitions aggregate multiple small groups into a purchasing coalition that negotiates PBM terms with the leverage of the combined population. The TPA can serve this function: aggregating its small group book into a pharmacy benefit relationship that produces better terms than any individual group could negotiate. A TPA with 50,000 covered lives across 500 small employers has negotiating leverage that a single 25 person group does not.

TPA negotiated carve outs separate the pharmacy relationship from the stop loss carrier’s bundled arrangement. This allows the TPA to optimize pharmacy independently, selecting a transparent PBM even if the stop loss carrier’s default arrangement uses a traditional PBM model.

Specialty Drug Management

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Specialty drugs require particular attention because they drive a disproportionate share of pharmacy spend. A single member on a specialty medication can represent $50,000 to $500,000 or more in annual pharmacy claims. The GLP-1 medications discussed in Series 09, the biosimilars that represent cost saving opportunities, and the gene therapies that create catastrophic single claims all fall into specialty drug territory.

The traditional PBM approach to specialty drugs often works against the employer. The PBM’s captive specialty pharmacy may charge the plan higher prices than independent specialty pharmacies would charge. The formulary may favor higher cost specialty drugs with larger rebates over lower cost alternatives with smaller rebates. Prior authorization requirements may be designed to manage utilization in ways that serve the PBM’s economics rather than the plan’s clinical needs.

A transparent PBM approach to specialty drugs passes through actual acquisition costs, allows access to independent specialty pharmacies, and designs formulary placement based on clinical value rather than rebate optimization. For a small employer with even one member on a high cost specialty medication, the difference between traditional and transparent specialty drug management can exceed the savings on all other pharmacy spend combined.

Site of care optimization is part of specialty drug management. Many specialty drugs can be administered in a physician office, an infusion center, or the patient’s home. The cost varies dramatically by site, with hospital outpatient infusion often costing three to five times what a home infusion or physician office administration would cost. A transparent PBM that routes specialty drug administration to the lowest cost appropriate site produces savings that a traditional PBM, which may have financial relationships with higher cost sites, does not pursue.

The Pharmacy Design Opportunity

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Pharmacy benefit design is where the gap between current practice and available improvement is largest. A small group employer who moves from a traditional PBM with spread pricing and no rebate pass through to a transparent PBM with pass through pricing can see 15 to 30 percent pharmacy cost reduction based on published analyses. For specialty drugs, the savings can be larger.

The regulatory environment is shifting toward transparency. The Consolidated Appropriations Act of 2026 limits PBM compensation to flat bona fide service fees in Medicare Part D effective 2028, mandates 100 percent rebate pass through, and requires any willing pharmacy network participation effective 2029. These requirements will restructure PBM revenue models. Surveys indicate that by 2027, 33 percent of plans intend to partner with a new or emerging PBM, suggesting meaningful market share shifts ahead.

The benefits architecture point is that pharmacy is not a commodity to be accepted as the PBM presents it. It is a design component where active management produces more savings per dollar of effort than any other ancillary benefit. The employer who accepts the TPA’s default PBM arrangement is practicing accretion. The employer who evaluates transparent PBM alternatives, understands formulary design, and manages specialty drug exposure is practicing design.

Closing

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The small group pharmacy disadvantage is structural but not inevitable. Alternative models exist. The savings are real and published. Pharmacy benefit design is the highest return benefits architecture decision a small employer can make, and it is the one most commonly left to the default.

An employer evaluating pharmacy options should ask whether the current PBM uses spread pricing, what percentage of rebates passes through to the plan, whether the formulary reflects rebate optimization or clinical value, and whether transparent PBM alternatives are available through the TPA. The answers to these questions determine whether pharmacy is costing the plan more than it should.

The employer should also ask about specialty drug management specifically: how are specialty drugs priced, which specialty pharmacies are available, and what site of care management exists for infused medications. A single high cost specialty drug member can produce more pharmacy expense than the entire remainder of the population. Managing that exposure requires attention that traditional PBM arrangements do not provide.

The TPA’s role in pharmacy benefit design is critical. A TPA that has negotiated favorable PBM terms across its book of business, or that has carved out pharmacy to a transparent PBM, provides value that the individual small employer could not access directly. The employer evaluating a TPA should ask about pharmacy arrangements as part of the TPA selection process, not as an afterthought once the relationship is established.