View from City Road: A pill the drugs industry must take

Merck set the agenda; SmithKline Beecham is following suit. It cannot be long before the herd follows in their wake and the drugs industry becomes crammed full of the likes of Diversified Pharmaceutical, the US pharmaceutical benefit management organisation for which SmithKline is forking out more than dollars 2.3bn.

SmithKline's decision to take the same path as the mighty Merck, which last November paid dollars 6.7bn for Medco, a grander version of Diversified, has answered the question of whether that purchase was a one-off deal or the start of a new-look drug industry.

When two of the world's three biggest drug companies make the same move, it begins to look awfully like a trend. Others, such as Glaxo, which hoped to be able to avoid taking such a step, increasingly seem to be left out in the cold.

Like Merck, SmithKline has decided that buying into the managed healthcare movement is the only sensible way to respond to the revolution taking place in the way drugs are purchased in America.

That shift started two years ago, when employers and the government alike concluded that the spiralling costs of health care were unsustainable and responded by creating HMOs like Medco - health management organisations whose function was to buy the essential elements of corporate health care in bulk as cheaply as possible.

Drug prices were a natural first target for cost control. So HMOs spawned PBMs like Diversified, whose job was to buy pharmaceuticals in bulk at discounted prices. PBMs are more than simply bulk purchasers of individual drugs, however; they also draw up 'formularies' - menus of approved drugs which in theory represent the most cost-effective combination treatments.

It rapidly became clear to drug groups that it would be as essential for a company to have its products represented on a formulary as it would to persuade the doctor to prescribe them in the first place.

It took Merck barely a year to decide that if it could not beat the PBMs it would have to join them and share in their profits instead.

There are considerable risks in buying a PBM; in particular 'capitation' - where a PBM offers to meet the drug needs of a company's employees for a fixed amount per head.

This involves risks akin to those taken by a life assurance company; not the sort of actuarial assessment drug companies are used to taking.

But if there are dangers, there are also synergies to be found in linking up with PBMs and HMOs - notably the ability to draw on pools of data about the cost and physical effectiveness of different treatments. For those drug groups that pick the right partner the rewards will be tremendous. Certainly the market's view of SmithKline's purchase was hugely positive. Those that refuse to jump on the bandwagon altogether, as Glaxo appears to be doing, may end up deeply regretful.