Fitch: China's Public-Hospital Reform Could Dampen Drug Makers' Profitability

Fitch Ratings says today that China's public-hospital reform, which aims to exclude drug sales from public hospitals' profit structure while focusing on income from medical services, will be a challenging and prolonged process. The near-term impact on Chinese pharmaceutical manufacturers is minimal, but over the long term, their pricing power could be at risk if public hospitals push for bigger rebates from them to compensate for lower profits from drug sales.

Chinese public hospitals, which account for 80% of drug sales in China, are widely seen as key drivers of drug-price inflation because they rely on profits from drug sales to compensate for losses from providing medical services at very low prices.

County and above-county level hospitals have incentive to purchase more expensive drugs from manufacturers to generate higher profit because they are generally allowed a 15% mark-up in dispensing drugs. This means that some hospitals may be more inclined to select drugs with higher prices to enter their procurement lists. It is also widely reported that the prices at which these drugs are sold to the hospitals tend to be well above the manufacturers' ex-factory prices. As a result, some manufacturers may transfer a portion of their profits to hospitals in the form of rebates to maintain relationships.

The ongoing public-hospital reform aims to alter public hospitals' profit structure by forbidding the mark-up on hospitals' drug sales and increasing medical service sales. The reform has made progress recently following China's National Development and Reform Commission's (NDRC) drafting of the medical-services price reform guidelines. The guidelines reportedly include cancellation of government price controls on certain medical services and adjustment of prices on certain medical services to reflect the value of tasks performed by medical technicians.

However, Chinese public hospitals are likely to have low incentives to alter the status quo and hence strongly resist reform measures, given the disproportionate share of drug sales in their profits. A potential risk that could undermine the reform is that hospitals may put pressure on Chinese drug producers to give even bigger rebates before their products to enter the hospitals' procurement lists, should the mark-ups be eliminated.

Fitch expects the reform process to be slow and the Chinese government would need to introduce further supporting policies to deepen the reform as well as to balance the interests along the healthcare value chain.