Group purchasing organizations receive flak from skeptics who wonder if the administrative fees they charge medical device and drug manufacturers drive up hospitals' supply chain costs.

But a new study by Purdue University researchers using the complicated mathematics of game theory suggests the fees cut into manufacturers' profits -- without raising the prices hospitals pay.

"The manufacturer's assertion [is] that they have to raise prices for everyone in order to cover the [contract administration fee]," Leroy B. Schwarz, a study co-author and professor of management at Purdue, told reporters in a call Tuesday. "However commonsensical that might seem, the math just doesn't show it to be the case."

In the study, researchers argue GPOs lower purchasing costs, particularly for smaller hospitals, and that administrative fees collected by GPOs don't distort their incentives to save.

The results come after medical device giant Medtronic Inc.'s February walkout on contracts with the GPO Novation, in a move some analysts called a "watershed moment" for the industry.

When asked on a call if the timing had been planned, Curtis Rooney, president of the Health Industry Group Purchasing Association (HIGPA), a GPO lobby, joked, "No, that would have been very clever though."

GPOs are middlemen who say they help member hospitals save money by negotiating contracts for them from suppliers. Because the hospitals couldn't drive much of a bargain alone, the argument goes, they could push for lower prices together because of the higher volumes.

More than 20 years ago, Congress passed a "safe harbor" provision that lets GPOs pocket administrative fees from vendors, typically to the tune of 3 percent of the volume contracted. It's estimated that GPOs net at least half their revenue through these payments.

GPO critics argue that these fees pose a conflict-of-interest problem, as they give the GPOs an incentive not to lower prices. Some critics estimate that repealing the "safe harbor" provisions would save the health care system billions of dollars a year.

Studies on GPOs' health care impact have been mixed. A 2006 report based on case studies from Novation suggested a contract price of $3,116 for providers buying directly from the manufacturer but only $1,749 going through a GPO.

But last fall, in a study commissioned by the Medical Device Manufacturers Association, economists compared GPO contracts with winning bids on an after-market auction service called MEMdata. They found the auction prices were 10 to 14 percent cheaper than the original GPO price over the 10 years of data they had available.

Model savings

To bring a more theoretical bent to the debate, in the current study, the researchers decided to explore a simplifying, but mathematically challenging technique called game theory.

Game theory was partly developed by John Nash, whose life was chronicled in the movie "A Beautiful Mind." It's a tool used by economists to model what happens when self-interested agents try to reach the best deal for themselves, or come to an "equilibrium," where each party is satisfied with its final choice. Possibly the best known example is the "Prisoner's Dilemma," a tricky scenario developed in the 1950s that explains why two suspects might rat each other out when it's seemingly in their best interest to keep silent.

Schwarz compared the model to working in a laboratory, where researchers create a highly controlled environment to eliminate extraneous variables. He cautions that because it's simplified, care must be taken when extrapolating the results to the real world.

In the Purdue "game," Schwarz and his colleagues include several providers or hospitals with different product requirements, but only a single manufacturer, a single GPO and a "competitive source" that can also supply the product.

The study assumes, naturally, that the manufacturer is seeking to maximize profits. It also assumes the GPO is trying to maximize its profits (through fees from manufacturers and dues from member hospitals). And it assumes providers and hospitals are seeking to minimize the total cost of purchasing -- which includes not just the price of goods, but the expense of evaluating manufacturers and hammering out contracts.

The study includes other assumptions, too, such as perfect knowledge among all the players about what each player is doing and about prices -- knowledge that, obviously, in real life would be far from perfect.

In the "game," the end result of these different agents planning and negotiating, the researchers say, is that raising or lowering the contract administrative fees, or CAFs, bites into manufacturers' or GPOs' profits, but doesn't affect providers' purchasing costs, no matter their size.

"In other words, CAFs sliding up, slides dollars away from the manufacturer to the GPO, and vice versa," Schwarz said.

However, the study also found that providers with smaller purchasing requirements will experience lower total purchasing costs but may actually experience higher per-unit prices. The researchers explained this by saying one must take into account the total costs associated with purchasing, and not just unit price.

"In thinking about total purchasing cost, [imagine] a friend of yours has told you that Sam's Club has a great deal on some product that you consume a lot of. In my case, it might be wine," Schwarz joked. "So do I immediately jump into my car and drive to Sam's Club? If it's next door, yes, but not if it's in the next town."

Schwarz speculated that with the addition of other GPOs, as in the real world, purchasing costs could be driven down further. The study does suggest some larger providers might not experience savings with the GPO, but Schwarz said that large providers are often part-owners of GPOs, so they could receive share-backs, which are not accounted for in the study.

"This is one of a growing body of independent studies that support group purchasing organizations," Todd Ebert, President & CEO, Amerinet, Inc. and Chairman of the HIGPA Board of Directors, said in a call with reporters.

The study, "The Impact of Group Purchasing Organizations on Healthcare-Product Supply Chains," will be published in a forthcoming issue of Manufacturing & Service Operations Management.