(Reuters) - India has put in place a $5.4 billion policy to provide free medicine to its people, a decision that could change the lives of hundreds of millions, but a ban on branded drugs stands to cut Big Pharma out of the windfall.

From city hospitals to tiny rural clinics, India's public doctors will soon be able to prescribe free generic drugs to all comers, vastly expanding access to medicine in a country where public spending on health was just $4.50 per person last year.

The plan was quietly adopted last year but not publicized. Initial funding has been allocated in recent weeks, officials said.

Under the plan, doctors will be limited to a generics-only drug list and face punishment for prescribing branded medicines, a major disadvantage for pharmaceutical giants in one of the world's fastest-growing drug markets.

Without a doubt, it is a considerable blow to an already beleaguered industry, recently the subject of several disadvantageous decisions in India, said KPMG partner Chris Stirling, who is European head of Chemicals and Pharmaceuticals.

Pharmaceutical firms will likely rethink their emerging markets strategies carefully to take account of this development, and any similar copycat moves across other geographies, he added.

But the initiative would overhaul a system where healthcare is often a luxury and private clinics account for four times as much spending as state hospitals, despite 40 percent of the people living below the poverty line, or $1.25 a day or less.

Within five years, up to half of India's 1.2 billion people are likely to take advantage of the scheme, the government says. Others are likely to continue visiting private hospitals and clinics, where the scheme will not operate.

The policy of the government is to promote greater and rational use of generic medicines that are of standard quality, said L.C. Goyal, additional secretary at India's Ministry of Health and Family Welfare and a key proponent of the policy.

They are much, much cheaper than the branded ones.

Global drugmakers like Pfizer, GlaxoSmithKline and Merck will be hit. They spend billions of dollars a year researching new treatments and target huge growth for branded medicine in emerging economies such as India, where generics account for around 90 percent of drug sales by value, far more than in developed countries.

U.S.-based Abbott Laboratories, which bought an Indian generics maker in 2010, is the biggest seller of drugs, both branded and generic, in India, followed by GlaxoSmithKline.

BIG PHARMA BLUES

In March, India granted its first ever compulsory license, allowing a domestic drugmaker to manufacture a copy-cat version of Nexavar, a cancer drug developed by Germany's Bayer, unnerving foreign drugmakers that fear a lack of intellectual property protection in emerging markets.

That enabled India's Natco Pharma to sell its generic version of Nexavar at 8,800 rupees ($160) per monthly dose, a fraction of the 280,000 rupees Bayer's version cost.

In another blow to Big Pharma's emerging market ambitions, China recently overhauled regulations to grant authorities the power to allow domestic drugmakers to produce cheap copies of medicines protected by patents.

Emerging markets are on track to make up 28 percent of global pharmaceuticals sales by 2015, up from 12 percent in 2005, according to IMS Health, a healthcare information and services company.

Most sales in emerging markets come from branded generics, which are off-patent drugs priced at a premium to those made by local manufacturers.

The Organisation of Pharmaceutical Producers of India (OPPI), a lobby group for multinational drugmakers in the country, argues that the price of drugs is just one factor in access to healthcare and that the scheme need not be detrimental to manufacturers of branded drugs.

I think this will hasten overall growth of the pharmaceutical industry, as poor patients who could not afford will now have access to essential medicines, said Tapan Ray, director general of OPPI.

About 600 billion rupees ($11 billion) in drugs are sold each year in India, or 482 billion at wholesale. Drugs covered under the new policy account for about 60 percent of existing sales, or 290 billion rupees at wholesale cost.

The government's annual cost is likely to be lower due to bulk purchasing and because patients at private clinics would still pay for their own drugs. States will pay for 25 percent of the free drugs and the central government will cover the rest.

Under various existing programs, around 250 million people, or less than a quarter of India's population, now receive free medicines, according to the health ministry.

India's new policy, to be implemented by the end of 2012 and rolled out nationwide within two years, is expected to provide 52 percent of the population with free drugs by April 2017, at a cumulative cost of 300 billion rupees ($5.4 billion).

That requires a major funding ramp-up from a deficit-strapped government. The scheme has been granted just 1 billion rupees thus far from central government coffers.

STRICT INSTRUCTIONS

Public doctors will be able to spend 5 percent of the budget, equivalent to around $50 million a year, on drugs outside of the government's list, on branded drugs or on medicines that are not on the list. Beyond that, they can be punished, said Goyal, the health ministry official.

If doctors are found to be prescribing medicines which are not on the list, or which are branded, then disciplinary action will be initiated, he said.

Free medicine is just one solution to better healthcare in India, where just getting to a state clinic can require a long journey.

Swapnil Yadav, who runs a clinic in Ambegaon, a village 170 km (105 miles) southeast of Mumbai, said India should set up free drug retailers instead of government clinics.

Patients can approach a private clinic and then get free medicines from government-run medicine shops, he said.

The free generics scheme, which mirrors policies in the states of Tamil Nadu and Rajasthan, is expected to be fully operational by the time voters go to the polls for the 2014 general election, when the populist Congress party will seek a third straight victory.

Indian makers of generics such as Dr Reddy's and Cipla are best placed to benefit.

The move will please the generics manufacturers who stand to gain substantially in competing for contracts, said KPMG's Stirling.

($1 = 56.9650 Indian rupees)

(Additional reporting by Kaustubh Kulkarni in MUMBAI and Ben Hirschler in LONDON; Editing by Tony Munroe and Raju Gopalakrishnan)

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