Strategic Transfer Pricing by Vertically Integrated Health Care Firms: Evidence from Medicare Part D

New research published by the National Bureau of Economic Research (NBER) reveals that vertically integrated healthcare corporations are utilizing sophisticated internal pricing mechanisms to bypass federal profit regulations, a practice that has significantly increased the financial burden on the United States government. The study, designated as Working Paper 35043 and issued in April 2026, provides a detailed empirical analysis of how insurers who own their own pharmacies manipulate the prices of prescription drugs to "tunnel" profits into unregulated subsidiaries. This strategic transfer pricing occurred in direct response to the implementation of caps on insurer profits within the Medicare Part D program, leading to a 9.5% increase in drug prices at pharmacies owned by integrated firms.

The findings suggest that the regulatory intent of the Medical Loss Ratio (MLR) and other profit-limiting measures is being systematically undermined. By artificially inflating the costs paid to their own pharmacies, vertically integrated insurers are able to report higher expenses and lower profit margins on their insurance operations, thereby avoiding the requirement to issue rebates to consumers or the government. The NBER analysis indicates that more than 20% of these inflated costs are ultimately subsidized by federal taxpayers, raising urgent questions about the efficacy of current healthcare oversight and the accelerating trend of consolidation within the medical industry.

The Mechanism of Profit Tunneling in Healthcare

At the heart of the study is the concept of "tunneling," a corporate strategy where profits are shifted from a regulated entity to an unregulated or less-regulated one within the same corporate umbrella. In the context of Medicare Part D, insurance providers are subject to strict regulations regarding their profit margins. Specifically, if an insurer’s administrative costs and profits exceed a certain percentage of the premiums they collect, they are often required to return the excess funds to the government or to policyholders.

To circumvent these restrictions, vertically integrated firms—entities that own both the insurance provider and the pharmacy or pharmacy benefit manager (PBM)—engage in strategic transfer pricing. When an insurer pays an external, independent pharmacy for a prescription, the transaction is a straightforward expense. However, when an insurer pays its own subsidiary pharmacy, it has the incentive to set that price as high as possible. Because the payment to the pharmacy is classified as a "medical expense" for the insurance arm, it helps the insurer meet its required spending ratios. Simultaneously, the "excess" payment is captured as profit by the pharmacy subsidiary, which is not subject to the same profit caps as the insurance provider.

The NBER researchers detected the most aggressive price increases among insurers that were at the greatest risk of exceeding allowable profit levels. For these firms, the 9.5% price hike at integrated pharmacies served as a financial safety valve, allowing them to retain earnings that would have otherwise been forfeited under federal law.

Historical Context and the Rise of Vertical Integration

The landscape of the American healthcare system has undergone a radical transformation over the last two decades, moving from a fragmented market of independent providers to a highly consolidated environment dominated by a few massive conglomerates. The timeline of this shift provides essential context for the NBER’s findings:

• 2003: The Medicare Modernization Act establishes Medicare Part D, creating a massive market for private insurers to provide prescription drug coverage to seniors.
• 2010: The Patient Protection and Affordable Care Act (ACA) introduces the Medical Loss Ratio (MLR) for private insurance, requiring insurers to spend at least 80% to 85% of premiums on healthcare services and quality improvement.
• 2014-2018: A wave of vertical mergers reshapes the industry. Notable examples include the acquisition of Aetna by CVS Health (which already owned the Caremark PBM) and the expansion of UnitedHealth Group’s Optum division, which integrated insurance, pharmacy services, and direct patient care.
• 2020s: Federal regulators begin applying stricter profit-cap frameworks to Medicare Advantage and Medicare Part D plans to control rising government expenditures.

As these regulations tightened, the incentive for firms to integrate vertically increased. By owning multiple links in the healthcare supply chain, companies could gain greater control over internal accounting and "opaque" pricing structures that are difficult for federal auditors to untangle.

Quantitative Impact on Federal Spending and Taxpayers

The NBER study utilizes a massive dataset of Medicare Part D claims to quantify the economic impact of these pricing strategies. The data shows a clear divergence in pricing behavior following the introduction of profit caps. While independent pharmacies maintained relatively stable pricing structures, pharmacies owned by integrated insurers saw immediate and sustained price escalations.

The fiscal consequences of this behavior are substantial. Because the federal government subsidizes a significant portion of Medicare Part D premiums and provides additional "reinsurance" for high-cost claims, the government effectively picks up the tab for the inflated transfer prices. The researchers estimate that more than one-fifth of the price increases observed at vertically integrated pharmacies were directly funded by the federal government.

In practical terms, this means that billions of dollars in taxpayer funds intended to provide affordable medication to the elderly are instead being diverted into the corporate treasuries of some of the nation’s largest healthcare companies. The study suggests that without these strategic price hikes, federal spending on Medicare Part D could have been significantly lower, potentially freeing up resources for other public health initiatives or reducing the national deficit.

Industry Responses and Regulatory Challenges

While the NBER paper presents a critical view of these practices, the healthcare industry has historically defended vertical integration as a means of improving efficiency and coordination. Industry trade groups often argue that "one-stop-shop" models allow for better management of chronic conditions and more streamlined data sharing between insurers and pharmacies.

In statements regarding previous inquiries into PBM and pharmacy pricing, major integrated firms have maintained that their internal pricing is reflective of market rates and the complex administrative costs associated with managing large-scale drug programs. They contend that the scale of their operations allows them to negotiate lower prices from drug manufacturers, a benefit they claim is passed on to consumers.

However, federal regulators and consumer advocacy groups have expressed increasing skepticism. The Federal Trade Commission (FTC) and the Department of Justice (DOJ) have recently signaled a more aggressive stance toward vertical consolidation in healthcare. Critics argue that the lack of transparency in "internal" transactions makes it impossible to verify if savings are actually being passed to the public or if they are being hidden through the "tunneling" methods identified in the NBER report.

Analysis of Broader Implications

The NBER working paper highlights a fundamental flaw in current healthcare regulation: the "Whack-a-Mole" problem. When the government regulates one aspect of the healthcare market (insurer profits), sophisticated market actors simply shift their profit-seeking behavior to an unregulated segment of their business.

This has several long-term implications for the U.S. healthcare economy:

1. Market Distortion: Strategic transfer pricing creates an uneven playing field. Independent pharmacies, which cannot benefit from an insurer-parent’s "tunneling" strategy, find it increasingly difficult to compete with integrated giants. This could lead to further market consolidation and reduced choice for patients.
2. Regulatory Obsolescence: If profit caps can be easily evaded through accounting maneuvers, the current regulatory framework may be rendered obsolete. Lawmakers may need to consider "entity-wide" profit regulations that look at the total profitability of a parent corporation rather than just its insurance subsidiary.
3. Inflationary Pressure: By incentivizing higher internal prices, current regulations may unintentionally be contributing to healthcare inflation. When a firm is rewarded for "spending" more on its own subsidiaries, the natural downward pressure on prices in a competitive market is removed.

Conclusion and Future Outlook

The evidence provided in NBER Working Paper 35043 serves as a warning to policymakers that vertical integration has provided a sophisticated toolkit for regulatory evasion. As the issue date of April 2026 suggests, this remains a contemporary and evolving challenge for the federal government.

Addressing the issue of strategic transfer pricing will likely require a multi-faceted approach. This could include mandatory transparency in internal corporate transactions, more rigorous auditing of Medicare Part D claims by the Centers for Medicare & Medicaid Services (CMS), and potential legislative changes to how profit caps are calculated for integrated firms.

As healthcare spending continues to consume a larger share of the U.S. GDP, the ability of the government to effectively regulate the industry’s largest players will be paramount. The NBER study provides the empirical foundation for a renewed debate on how to ensure that healthcare regulations actually protect taxpayers and patients rather than merely incentivizing creative accounting. For now, the "tunneling" of profits remains a lucrative loophole that underscores the complexities of managing a privatized insurance system with public funds.