Background <p>In 2018, China’s National Healthcare Security Administration initiated a transformation of drug procurement towards national volume-based procurement (NVBP) of drugs, which disclosed the quantity information in the procurement auction, effectively reducing drug prices. We aim to theoretically and empirically shed light on the markup channel for the price effect, and explore the welfare effect of NVBP reform.</p> Methods <p>Based on the price discovery mechanism of reverse auction and the comparative analysis of the centralized procurement system before and after the reform, this study theoretically analyses the effect of the NVBP on pharmaceutical companies’ pricing strategies and the welfare consequences of the policy. Our theoretical model predicts reduced drug prices and increased procurement volume after the reform. We then empirically test these predictions by performing a difference-in-difference (DID) exercise on pharmaceutical firms’ markups and sales.</p> Results <p>The DID results show a significantly negative impact of NVBP on pharmaceutical firms’ markups (−0.0378, significant at 1%), a significantly negative effect of NVBP on markups for the chemical medicine producers with a larger scale of coefficient (−0.0411, significant at 1%), while a negative but insignificant coefficient for the other medicines (−0.0219). The results also show a significantly positive effect of NVBP on pharmaceutical companies’ sales (0.148, significant at 1%).</p> Conclusions <p>The NVBP reform reduced the markups of pharmaceutical firms. The chemical medicines, which were highly exposure to the policy shock, were affected significantly, while the effect on the other types of medicines is weak. The NVBP reform also promoted the sales of medicines, and thus improved the social welfare. A further mechanical analysis shows that these results are mainly driven by a removal of market uncertainties, corruption, and transaction costs in the procurement process.</p>