Optimal selection of medical formularies

The rising cost of drugs is drawing scrutiny from many policymakers to the design of medical formularies. Formulary design is difficult because of the need to account for heterogeneity in patient characteristics, and the potential variation of cost‐effectiveness of drugs across multiple conditions that they might be used to treat. In this article, we formulate the problem of selecting a medical formulary to minimize the cost of providing the drugs in the formulary, as well as the negative consequences to both patients and providers of the restrictions of the formulary. We model multiple drug categories and random variations in patient characteristics. We assume that patients are advised by physicians who are informed about the relative effectiveness of drugs that are available, and always make a rational choice to obtain the best expected outcome for their treatment. We derive insights into the structure of the optimal formulary under both certain and uncertain information about drugs’ effectiveness. Our model shows that widely used heuristics for drug selection that employ average or incremental cost‐effectiveness ratios can perform very poorly. The model also shows that it is much more cost‐effective for the payer to keep physicians informed about the relative effectiveness of drugs so that they can help patients to make customized choices, rather than to restrict the formulary for quality‐control purposes.