Drug Pricing Part 2: The Pharma vs. Health Insurance Showdown

This is part 2 of a 3-part blog post on drug pricing. To read part 1 of this series on the role of pharma companies, click here. Part 3 will focus on the policies our 2016 presidential candidates are proposing.

In part 1, we looked at the drug pricing strategies of pharmaceutical companies. But the story of how U.S. drug prices are set doesn’t end there. Health insurance plays a key part, too. In fact, pharmaceutical companies and health insurance engage in a tug-of-war behind the scenes each and every day.

This is because one crucial difference sets healthcare apart from other industries:

The Consumer Does Not Pay for Goods

Whereas most industries operate in a traditional consumer-producer exchange of money for goods, health insurance plays an intermediary role and pays for the consumer’s expenses.

You may wonder — “that doesn’t sound right. When I buy a prescription drug, I can pay upwards of $75.” That’s true. You as the consumer do pay for a part of the cost, known as a “co-pay.” However, this is often only a fraction of the total drug cost. This is where health insurance kicks in.

Health Insurance Pays for Your Medical Expenses

Your health insurance pays for the majority of all “necessary” medical expenses, including drugs. Your health insurance supplements your co-pays to your pharmacist or doctor with its own payments.

Health insurance companies are known in the industry as “payers” because they “pay” for things. Aetna, UnitedHealth, and Express Scripts* are examples of payers. Some, like Aetna, may pay for all your medical expenses; others, like Express Scripts pay* only for your drug-related expenses. And finally, there are the government-run payers: Medicare for seniors 65+ and Medicaid for low-income individuals.

Why Have Payers in the First Place?

Frankly, it’s good business. While it sounds like a poor business model to pay for others’ expenses, payers reap large profits. Take your average car insurance. Drivers pay to be covered by car insurance. The majority of these drivers may never be involved in an accident. The payments these “safe” drivers make go on to cover the costs of car repairs that “dangerous” drivers incur. Any amount left over is profit for the car insurance company.

Car insurance operates on 2 principles:

• Principle #1. Minimize the number of dangerous drivers covered. If you can have more “safe” than “dangerous” drivers, that means the car insurance company is likely to see fewer accidents. The company can keep all the juicy payments that “safe,” non-accident-prone drivers make, while rarely paying out for repairs.
• Principle #2. Pay as little as possible for damages. When your “dangerous” drivers are involved in accidents, ensure you pay as little as possible. This includes: (a) ensuring all claims by the bad driver are accurate [i.e. validating there really was an accident] and (b) paying for the cheapest, bare necessities of repair.

The same principles apply to health insurance. A successful health insurance company covers a lot of healthy people and few unhealthy people. Prior to Obamacare, why were so many patients denied coverage? Because if a health insurance company knows you are unhealthy, then it’s not good business to cover you.

What Does this Mean for Drug Pricing?

See “Principle #2.” Because health insurance pays for your drug costs, it’s in its best interest to (a) validate that you truly need this drug and (b) pay as little as possible for the drug.

Naturally, this leads to a never-ending battle between the pharmaceutical and health insurance industries. (Aside: doctors and hospitals also play a large role in this battle, which I will explore in a future post).

Payers Keep Pharma in Check

As we saw in the previous post, there are many methods pharma can employ to exaggerate a drug’s benefits to increase its price. To counterbalance this, the payer uses its leverage to challenge pharma.

What sort of leverage does a payer have? The payer’s leverage is relative to how many members it covers (a la the number of drivers covered by one car insurance company). A payer can 1) refuse to pay for the drug or 2) put barriers that inhibit its members’ “access” to the drug.

Access is an important term — it defines how easily a member/patient can get a drug. Just as car insurance can overload you with steps to file a car damage claim (e.g. obtain witness statements, file police reports, submit pictures), payers can also impose multiple steps for drugs. Common methods include requiring the patient to try older, cheaper drugs first before the payer will pay for the newer, expensive drug.

Another method is to provide financial incentives to the patient: if a patient wants a generic drug, that’s a $5 co-pay, but if a patient wants the new drug, that’s a $75 co-pay. The patient will likely try the cheaper option first. (Co-pays bear little relation to what the actual cost of the drug is. Co-pays are used to incentivize you to take the drug the payer wants you to take).

So how does this negotiation process between pharma and payers on price and access work?

Step 1: The Payer Challenges the Data

Let’s look back at “Drug AWESOME.” We claimed earlier that it cures all headaches. Which types of clinical studies did we pursue to prove this claim?

• Study 1: We asked the patients how they felt before and after taking the drug. Before taking the drug, patients reported on a scale of 1–10 that their headaches hurt at level 10 intensity. After taking the drug, their headaches are reduced to level 7.
• Study 2: We measured the patient’s cranial blood pressure as a proxy for headaches. Cranial blood pressure was measured before and after taking the drug. After taking the drug, average cranial blood pressures dropped.

The payer claims Study 1 is inaccurate because it relies on too many variable factors: how the question was asked, how sociocultural backgrounds affected ratings, etc. Also, the reduction from 10 to 7 may be too small to be meaningful.

Study 2 is also flawed, the payer claims. While it may use a more objective measure, no one has proved that cranial blood pressure is a consistent metric for headaches. Low pressure may not mean less severe headaches.

This is just a sliver of the debates that occur. It’s not always clear who’s right. Perhaps the payer is not sophisticated enough to understand the results. Or perhaps pharma is overselling the data.

Step 2: The Payer Challenges the Price

The payer notes that another headache drug, “Drug GREAT,” is launching soon. The payer believes this drug will launch at a lower price.

The payer may threaten that if we don’t drop prices for “Drug AWESOME,” it will impose multiple access hurdles to our drug. Perhaps it will force patients to try Advil before trying “Drug AWESOME.” Or perhaps, when “Drug GREAT” comes out, the payer may give it a much lower co-pay of $10 and set “Drug AWESOME” at a much higher $75 co-pay. What patient would ever want to pay $75 for our drug when “Drug GREAT” is $10?

Back at our company, we decide to give into this payer’s threats. We offer this payer a 30% discount from our $23,720/year list price to $16,604/year. The payer is amenable to this price and agrees to cover our drug with minimal access hurdles.

Yin and Yang: The Balance of Pharma and Payers

It’s an endless, daily battle. Drug prices are also regularly renegotiated as new data or competitors emerge. Some payers are more lenient in negotiations. Some are much tougher. The free market encourages these payers to compete for better deals on prices. In theory, prices should drop.

So Why are Drug Prices Lower in Every Other Country?

When you have a dozen insurance companies negotiating individually with pharma, their respective buying power goes down. For example, if pharma wanted to sell a drug in the U.K., there is only one buyer of drugs: the British government. So either pharma accepts what the U.K. is offering for the drug, or pharma can’t sell in the country. (Aside: It’s more complex than this. The question of how other country payer systems work will be discussed in a future post).

By contrast, in the U.S. neither Medicare nor Medicaid directly negotiate with pharmaceutical companies.

The Upside and Downside of Payer Negotiations

• Upside: Payers check pharma’s drug claims. Payers check the claims of pharma companies. They conduct the diligence consumers cannot.
• Downside: Payers work in their own interest to lower prices. The skepticism of payers can often be taken a step too far. They may fail to recognize the true benefits of certain drugs in a blinded effort to reduce costs. This can hurt a patient seeking access to a drug, but is denied it because pharma-payer negotiations failed. In addition, restrictive and complex pharma-payer contracts may exclude new competitors that may be better. (Aside: pharma-payer contracts can get messy and deceptive — another topic for another day).

When are Payers Effective in Lowering Prices?

• When there are competitor drugs. Just as in the example of “Drug AWESOME” vs “Drug GREAT,” payers can pit competitors against each other to get to the lowest price. The drawback is that this leaves a lot of discretion to the payer to determine which drugs are alike, a role better left to doctors. (For instance, Express Scripts denied access to Glumetza and Sovaldi because of cheaper alternatives).
• When the drug treats a “minor” disease. In the case of “Drug AWESOME,” headaches are uncomfortable, but is treating it really necessary? Relative to cancer, headaches are a minor discomfort. Using this justification, a payer can choose to deny access to “Drug AWESOME.” On the other hand, payers might not want to disregard how debilitating severe headaches can be and how it can worsen other aspects of the patient’s health.
• When public pressure is on their side. Payers can point the finger at pharma. When Sovaldi launched at $85,000/year, payers everywhere publicly denounced its high costs.

Nevertheless, payers are often limited in their ability to dramatically impact prices. If “Drug GREAT’s” company sees that “Drug AWESOME” is priced at $23,720/year, then it may marginally lower its price to $21,000/year. At the end of the day, the pharma company with “Drug AWESOME” still sets the range of prices.

Which Brings Us Back to Pharma Bro…

Why is it that payers are having a hard time with Pharma Bro?

• There are no competitors. We’ve covered that; Pharma Bro owns a monopoly on this drug.
• There is a high medical need for the drug. Without it, patients could die. Moreover, this drug is necessary for only 2,000 patients. For a payer to deny access of this drug to such a small number of patients would be unethical and lead to terrible PR for the payer. In fact, it’s become quite common for pharma companies to target rare, orphan diseases for drugs, partly because pricing negotiations are easy. (This trend has become a contentious topic in healthcare).

Rising Drug Prices Are Bad for Everyone

Rising drug prices cut into the profits of health insurance. In fact, many have been merging to negotiate better prices. But what does this mean for us?

• Rising Premiums. As with car insurance, we all pay a “premium” or a regular fee to be covered by health insurance. When drug prices go up, payers pay more, and thus make less money. When payers make less money, they boost premiums.
• More Tax Dollars Funding Medicare and Medicaid. Medicare and Medicaid peg their drug pricing to what private payers negotiate. If private payers can’t negotiate good prices, then Medicare and Medicaid pay more. What funds Medicare and Medicaid? Our taxes.

There are other factors contributing to why health premiums have risen by nearly 20–40% in the past few years; however, rising drug prices is a substantial one. Insurance may continue to cover our drug costs, but we make up for it daily by paying skyrocketing premiums and rising taxes. These issues will only become more pressing if rising drug costs continue unabated. Up next on this blog, I’ll discuss what our 2016 presidential candidates are proposing to tackle this issue.

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*Express Scripts is a Pharmacy Benefit Manager (PBM). PBMs are not technically payers, but make their business by negotiating drug prices on the payer’s behalf. The payer will then pay the drug prices the PBM negotiates. For the purposes of this article, I do not distinguish these organizations from payers.